Tax-Efficient Diversification of a Concentrated Portfolio through Margin and Shorting

Abstract

We look at the rewards and risks of two tax-efficient strategies for diversifying a 10-stock basket of appreciated stocks in a separately managed account. Our long-only strategy requires an upfront partial liquidation whose after-tax proceeds are used to fund a diversified loss-harvesting portfolio. Losses are used to lower the weight of the remaining concentrated positions’ tax neutrally. Our margin-and-shorting strategy complements the 10-stock basket with a dollar-neutral loss-harvesting portfolio. An upfront liquidation is not required, although steep financing costs are associated with short positions in the loss-harvesting portfolio. Examining these strategies over many historical periods, we find that both diversification strategies typically generated portfolios with forecast tracking errors at roughly 1% on average at a 10-year horizon. The margin-and-shorting strategy delivered more tax alpha than the long-only strategy, however, for an investor with an initial investment of at least $10 million.