E370: What Taxable Investors Still Get Wrong About Returns

Summary

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Podcast Summary: How I Invest with David Weisburd

Episode E370: "What Taxable Investors Still Get Wrong About Returns"

Date: May 15, 2026
Host: David Weisburd
Guest: Chang (Top-performing banker at JP Morgan, former Goldman Sachs PWM)

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Overview of Episode Theme

This episode dives into the concept of tax alpha and why it's particularly relevant for taxable investors today. David and Chang discuss practical strategies for maximizing after-tax returns, dissect the mechanics and risks of popular tax loss harvesting products, and debate when it truly makes sense to realize gains and diversify single-stock exposure. The conversation balances practical guidance, technical explanations, and behind-the-scenes industry insights, with a strong emphasis on manager and product selection.

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Key Discussion Points & Insights

1. Why Tax Alpha Matters Today

• Tax Alpha means optimizing investment strategy to maximize after-tax returns.
• Chang underscores that all true spending—tuition, mortgages, expenses—uses after-tax dollars, making after-tax returns paramount.

  “As taxable investors, we all eat after tax returns, right?... The vast majority of the investment management industry is built around the idea of pre-tax returns...But the reality is...We pay for our kids’ school tuition...Those are after tax dollars.” (Chang, 00:10)

2. Mechanics of Tax Loss Harvesting Strategies

• Growth in tax-aware SMAs (Separately Managed Accounts) and long/short strategies.
• Core methods: buy a diversified portfolio, use portfolio margin or leverage, and actively realize losses through long and short trades.
• Outperformance (pre-tax alpha) is necessary to offset costs like fees and interest.

  “You have to outperform that hurdle before you even think about the tax side.” (Chang, 01:19)

• Volatility, both up and down, increases the pool of harvestable losses.

  "You’re concurrently long and short...volatility is going to be a tailwind...more loss realization." (Chang, 02:29)

3. Importance of the Alpha Model & Manager Selection

• The alpha model (how long and short baskets are constructed) is a major differentiator.
• Harvesting cadence (weekly vs. monthly, etc.) is mostly systematic and less critical than stock selection.

  "Where the differentiators lie are how they're creating those long and short baskets." (Chang, 04:31)

4. Tracking Error—Risk or Opportunity?

• Tracking error allows managers freedom to deviate from the benchmark—they might outperform, but can also underperform.

  “It’s the latitude you’re providing the manager to roam...You can track much to the upside. You can also track to the downside.” (Chang, 04:54)

5. Approaches to Single-Stock Diversification Events

• Discussed strategies for holders with large capital gains in single stocks (e.g., SpaceX, Anthropic, OpenAI).
• AI guidance: To justify not selling and reinvesting, the original stock must have extraordinary compounding—often 30-40%+ annualized—just to break even after accounting for taxes and lost tax alpha.

  “I would need to get like a 30 to 40% compounded annual yearly return on the stock for it to just break even.” (David, 06:40)

• Empirical insight: the most common stock outcome is -100% (total loss).

  "If you look at...the CRSP database, the most frequent or common outcome...is a minus 100% return." (Chang, 08:03)

Memorable Quotes

“You’re sort of rearranging the deck chairs...shifting something from ordinary loss to long term capital gain...because of the derivatives expression of these economic substance ideas.” (Chang, 29:14)

6. Portfolio Construction, Fees, and Operations

• Oversight and longevity of the provider are critical given operational complexity of highly levered, high-turnover strategies.

  "You want to make sure that firm has navigated all sorts of volatile markets...Are they set up operationally? Is there the risk management?" (Chang, 16:25)

• Fees typically range from 45 to 200 basis points; no “carry.” Minimums have dropped, making it more accessible.

  "Charles Schwab just lowered their minimums." (David, 17:55)

7. Extension to W2 Income & Management Fees

• Newer trend: Using tax-aware hedge funds and structures to offset earned income or management fees for high-earning professionals.
• Requires “qualified purchaser” status, significant minimums, and cautious CPA/legal review.

  "You want to talk to the CPA beforehand and, you know, on occasion, maybe the managers will be able to provide you with a prior K1." (Chang, 25:54)

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Timestamps & Important Segments

• 00:10-02:21: Why after-tax returns matter; mechanics of tax-aware SMAs
• 02:21-03:32: How volatility supports tax loss harvesting; industry players
• 04:07-04:42: Differentiating by alpha model, not cadence
• 04:42-05:31: Tracking error as latitude, not just risk
• 05:31-09:17: Should you diversify single-stock gains immediately?
• 09:25-10:11: Tax harvesting most useful for major gain realization events
• 12:26-13:51: Reframing tax loss strategies as portable alpha/true portfolio improvement
• 15:01-17:02: Explosion in products, risk of 'tax tail wagging the dog', importance of quality operations
• 17:06-18:47: Fee structures and minimums
• 18:47-19:09: Expanding strategies for W2 income—family office perspectives
• 23:29-24:08: Portable alpha via derivatives and structured products
• 29:27-30:47: Tax aware strategies in hedge funds, real estate, and (lack of) credible approaches in crypto
• 32:00-34:39: Cautions about proliferation of poorly-substantiated products and fee gouging
• 34:39-36:11: Why Russell 3000, not S&P, is preferred for tax loss strategies
• 36:11-39:04: Passive flows, index inclusion's growing impact, and consequences for private/public valuations
• 39:04-40:23: Using option-based lending and institutional-grade credit for liabilities

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Notable Quotes & Memorable Moments

• On Single Stock Risk:

  “If you look at all the say 20, 30,000 stocks that are in the CRSP database, the most frequent outcome is minus 100%. The most common. Yeah.” (Chang, 08:03)

• On Overpaying For “Tax Alpha” Products:

  “They charge as much as 2.95% on the management fee...historical returns, it’s underperformed by roughly 2.95% to the index. And sure, you get losses. But it kind of begs the question like why would I do this?” (Chang, 32:42)

• On Economic Substance:

  "The economic substance doctrine. Right. It's one, is your economic position meaningfully changed? And two, if it weren't for the tax benefits, like would you still do this?" (Chang, 33:46)

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Key Takeaways for Listeners

• After-tax returns, not pre-tax, drive real-world wealth and spending.
• Tax-aware strategies are valuable—if the underlying investment process is strong. Focus on pre-tax alpha and operational robustness.
• Don’t let taxes dictate all investment decisions: Avoid letting “the tax tail wag the dog.”
• Diversifying single-stock exposure is almost always statistically favorable—few stocks outperform the opportunity cost, especially after taxes.
• Product selection matters: Exploding interest in tax loss harvesting has created a proliferation of products—many are overcharging and underdelivering.
• Operational experience and risk management are as important as fees.
• Index inclusion and passive flows have outsized influence on public market valuations.
• Innovative borrowing/lending strategies (e.g., box spreads) are lowering costs for sophisticated investors.
• **Always consult a knowledgeable CPA/tax attorney—**especially for more aggressive tax-loss or fee-offsetting strategies.

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Final Thoughts

This episode is a must-listen for investors with meaningful capital gains, income, or concentrated stock positions, as well as those seeking true after-tax optimization. Chang and David encourage a healthy skepticism towards product marketing and warn against prioritizing taxes over robust investment process and substance.

“Before doing it, investors can be very thoughtful about things like manager selection, strategy implementation. There’s just been an explosion of these products.”
(Chang, 15:01)

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For investors and managers looking to maximize their after-tax returns in an increasingly complex financial landscape, this episode provides both the technical understanding and practical skepticism required to navigate the tax alpha revolution.

Transcript

[David]

Chang, you're the top performing banker at JP Morgan. You're also at Goldman Sachs, PWM before. And you, like me, are a tax alpha nerd. Why is tax alpha so topical today?

[Chang]

As taxable investors, we all eat after tax returns, right? Like the vast majority of the investment management industry is built around the idea of pre tax returns. Everyone builds portfolios around it, right? We look at that. But the reality is when we pay for our kids school tuition, we go out to eat for families, we pay our mortgages. Those are after tax dollars. And so this idea of tax alpha, you know, how do you really restructure your assets, your liabilities, your overall balance sheet to really be thoughtful about after tax returns? Super interesting space. There's a ton of innovation going on right now.

[David]

A lot of people see this as a niche topic or just wealth managers. I love to talk about this. For somebody that does have capital gains and whether they're selling shares or whether they have carry that they're bringing in, what are the different options and what are the trade offs there you have

[Chang]

to be very thoughtful about manager selection. There's a huge proliferation of products of this whole longshore tax aware SMA space and mechanically I think most of us get it. Where you have a core portfolio, you use margin, whether it's reg T or portfolio margin, you go long and short a basket of stocks. As investors, what we should really care about is how are those long and short baskets constructed, what is the stock selection, what is the alpha model that's going into picking those stocks? Because it's precisely that stock picking that's going to produce that pre tax alpha. And these strategies really only work well when you have abundant pre tax alpha because they're embedded costs, there's like financing costs, there's fees, etc. So you have to outperform that hurdle before you even think about the tax side. But to your point, to get that additional alpha you often have to take tracking error, right? Or you have to leverage the portfolio and it's within that tracking error that you can produce a lot of tax loss realization. You can imagine if you have a core portfolio and you went 3x long, 2x short, markets that go up those shorts are going to lose a ton of money. You're going to have a lot of losses that you can potentially realize. If markets go down, those longs are going to have a ton of losses as well that you could potentially realize. So the magnitude of those losses, right? If you're 3x long, 2x short, right? It's 5. Right. Which is significantly greater than if you were doing, say for example, long only direct indexing tax loss harvesting approach. So that's why you get so many losses. And it happens to work pretty well in both up and down markets.

[David]

Is it just proportional to the volatility in the market? The more volatile, the more losses, even if that volatility is to the positive or if it's a negative?

[Chang]

Yeah. And because you're concurrently long and short up or down markets, you know you're going to have losses. But to your point, volatility is going to be a tailwind where you see a ton of volatility. Right. There's stocks like trading up and down, you're going to have more loss realization.

[David]

Is this daily, monthly, yearly volatility, Is it like you have a war with Iran and it goes up and then it goes down. Is that positive for tax loss harvesting?

[Chang]

It's so hard to say because all of the managers that run these strategies take different approaches. Some are incorporating very complex, sophisticated alpha models to pick stocks. Others might be just leaning into different factors. So you'd really have to dissect the long and short extensions. But I would say that, you know, in general, like that volatility, that tailwind is going to produce, you know, a ton more losses, you know, versus like, you know, low volume regimes.

[David]

And the two big players in the tax loss harvesting space to date, Quintino and aqr, with AQR being significantly bigger,

[Chang]

they're roughly about the same. And yeah, they're really the two kind of foremost firms that have been pioneering a lot of these strategies. But there's a ton of new players entering the market as well, including fintechs, various hedge funds, asset managers, etc.

[David]

Are there any other good ones that investors are excited about?

[Chang]

Ones that I look at closely? Brooklyn Investment Group, which is right here in the city, they're very interesting. They were started by a former Goldman Sachs managing director, very thoughtful guy. They're doing some very interesting things. And then a number of the large asset managers, they run these strategies. BlackRock, I think JP Morgan's coming to one. What we've seen with the larger asset managers, I think they tend to run a little bit lower on the tracking error or the leverage. Whereas the hedge fund firms, they're comfortable going, for example, 300 long, 200 short.

[David]

And how would somebody like a Brooklyn comes in? How are they differentiating against the AQR and Clintinos of the role?

[Chang]

Yeah, it comes down to the alpha model. And how are they really constructing the long and short baskets of stocks. And that's an area that, you know, we would really encourage. Like any investor who's looking at this, that should be the starting point. And you should go really deep on that question.

[David]

Why are you so focused on the alpha model and not on the leverage, the loss realization?

[Chang]

It's generally very systematic. And sure, you know, some of the providers or managers might harvest losses every three weeks. Some might do it every week, maybe every month.

[David]

Right.

[Chang]

That cadence may vary, but effectively it's very systematic and it's very, you know, similar across different managers, but where the differentiators lie are how they're creating those long and short baskets.

[David]

And I've asked this to a lot of wealth managers, and they all look at tracking error as a negative. But to me, tracking error is manager skill. Is tracking error just another word for manager skill? How should investors think about this?

[Chang]

It's the latitude you're providing the manager to roam a little bit more freely. Right? Like if you and I were picking two baskets of stocks and you picked exactly what was in the S&P 500, I picked some stuff that was different, but mostly like the S&P 500, I, I'll have higher tracking error than you are. By giving a Manager, say, a 6% or 8% tracking error budget, you let them roam, you know, more freely to deviate from the benchmark. That said, you know, it's not exactly a, you know, reflection of the manager's skill because tracking error cuts both ways.

[David]

Right?

[Chang]

You can track much to the upside. You can also track to the downside. So with that, you can have periods where, you know, the manager can be underperforming the benchmark by quite a bit. Right. In addition to outperforming different periods, is

[David]

there any rationale to put a single stock exposure into one of these strategies? Or should investors just wait until January 1st, sell it, and then put the cash into the.

[Chang]

That's a great topic you brought up. And it's something like I'm super interested in. So, for example, I think the first thing is what do you want to do as an investor? Right? Do you want to diversify? Do you want to hold it? What's your view or your comfort level of risk? Right. Wearing single stock risk. And then it also comes down to the manager. Right. Some managers will say, oh, that's too new of an IPO issue. It's too small cap. We don't want to run a long, short strategy. Right. But if it's a name like a Google, you know, meta Apple generally, they'll be okay with it. Back to the investor's perspective is, well, if you want to diversify it, well, there's a ton of options out there, right. You can use a long, short sma. You can do an exchange fund. Are you worried about huge drawdowns in the stock? If so, you may not want to seed one of these SMAs directly with the stock. Maybe you want to hedge it first. Right. And then when you're hedging it, do you want to go list it or otc. Right. So there's like a slew of these decisions that like every investor probably needs to think through. Because before they press, go on one

[David]

of these strategies, because I'm thinking about it, I had an exit with Circle in 2027. I expect both SpaceX and Anthropic, as in the $4 billion valuation for Anthropic. So now it's creating.

[Chang]

That's creating.

[David]

It's great, but it's creating significant tax decisions. When I consulted, AI basically said that I should sell and tax loss, harvest it because the compounding return on the stock needs to be so incredibly high to justify not selling it. And this is absent of even just diversification. So even if diversification wasn't a thing, I think it was something like I would need to get like a 30 to 40% compounded annual yearly return on the stock for it to just break even.

[Chang]

Not selling well, first and foremost, again, always hinges down to what's your view or comfort level carrying that stock on your balance sheet or in your portfolio. If you're like, I want to get out of here, I want to diversify. Right. Like, there's a ton of different ways you could just sell it in January. First, take that cash seed. One of these strategies, try to realize as many losses as you can over the course of the year. You might get close to have an entire position. Now you've created a basket of losses that could potentially mitigate, defer, you know, the capital gains you're realizing. So in that regard, right? Yeah, I mean, and you reinvest that capital after you sold it, right. Like you're going to continue compounding in a very diversified way. That's one outcome. And I think that's maybe that where AI is backing to the 30, 40% return. The reality is, if you look at empirical research, I think it's like the, you know, CRSP like database, the most frequent or common outcome in the history of like U.S. stocks, like the mode.

[David]

Right.

[Chang]

And is a minus 100% return.

[David]

Right.

[Chang]

That's the most. It's not saying like every stock is going to go to minus 100, but that's the most common outcome.

[David]

What do you mean by that?

[Chang]

So if you look at all the say 20, 30,000 stocks that are in the CRSP database, the most frequent outcome is minus 100%. The most common. Yeah. So the.

[David]

You mean going to zero.

[Chang]

Going to zero. Yes.

[David]

But isn't that through acquisitions and.

[Chang]

No, it's, you know, companies fizzle out, they go away. I mean, it takes decades and years, but it's, it's not like. But that is the reality of, of the empirical data.

[David]

That's fascinating. But absent that, again, going back to AI because of the compounding in the taxes and the tax laws harvesting, I believe the number was like 38 or 40% compounding to justify a hold. So let's say I'm super bullish on anthropic and SpaceX, which I am over 10 years, they would have to go up another, call it 50x for me just to break even. How does it ever make sense to hold them?

[Chang]

When you say break even, what does

[David]

that break even against? The tax loss harvested index.

[Chang]

That's interesting. I'd be curious to see that math because let's say like you start with a hundred dollars of SpaceX and then you pay the taxes, right? You can. Or you invest it and then you can offset those taxes, compound at, I don't know, 8 to 10% over 10 years. That's one path. And then the other path, you're saying if I had $100 of SpaceX, I'd have to go at 38%.

[David]

Guess one is what's wrong with that model. And two is going back to my question, why doesn't it always make sense to sell?

[Chang]

The heuristic I'd use is like let's say you had a hundred dollars of the single stock SpaceX to sell it in New York or California, where I live, you're taking a roughly 37 haircut so you can start compounding from $63. It takes a lot if you don't

[David]

do it on January.

[Chang]

If you do it. Yeah, if you, if you do it,

[David]

you do it December 31st.

[Chang]

Inefficient tax way, right? Just like sell, diversify now you have to return 50% almost roughly 37 to get back to the 100 starting point and then keep going. The ability to defer to sell the 100 and keep it right and diversify it, whether it's in a long, short, tax aware and continue compounding from that level, that's incredibly powerful, right? When you can imagine you do that over an investor's lifetime, it makes a meaningful difference.

[David]

And what about those numbers that 30%? Is that, is that flawed rationale?

[Chang]

The one crux is those like these strategies in general, right? They're only really helpful if your capital gains are realized, you know, in large chunks. They're not suitable or appropriate frankly for every investor, right? Not all of us need to have millions and millions of dollars of capital realizes in our back pocket, right? So you have to have a capital gain realization event. Whether it's a sale of your business, you have a concentrated single stock where you have embedded gains. Maybe you're selling a home or some other asset. That's when these losses actually can get useful in that they are deferring your gain.

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[David]

to play devil's advocate, we have a lot of GPS and family offices and LPs. But let's just say, obviously billionaires can use this strategy very aggressively. But let's say you're a gp and let's just say every year you're getting a million dollars in capital gains. Middle class gp.

[Chang]

Yeah.

[David]

And you take one and a half million dollars, you put it to generate over 10 years, call it 7 times 1.5. So $10.5 million in capital gains to offset that 10 years of $1 million a year. In that case, you would be realizing 30% of Alpha every year.

[Chang]

Yeah, that's correct. But here's the thing. I would slightly push back on that and say, would encourage this GP to reorient his or her thinking. And don't think of it as like, hey, I just got to build up losses to throw against my capital gains. You should maybe be thinking like, hey, I might have a core portfolio of ETFs or stocks or even mutual funds. It looks and feels like a roughly diversified basket of stocks and bonds or whatever exposure is an asset classes. What a great idea to introduce portable alpha, right? I can use a long, short SMA overlay where I hire a really great, you know, renowned hedge fund. They come in, they provide a long basket and a short basket of stocks around my portfolio. I've introduced a diversified source of return. I've built a better portfolio. Oh, by the way, it's really nice that these losses also come off the long and short extensions. On a year yearly basis. I happen to have a million dollars in capital gains. Great. Let me go talk to my tax advisor. Maybe there's something there. Right.

[David]

Why think of it in that way?

[Chang]

The rationale for doing all of this tax stuff, right. Like we see this, you know, kind of starting to creep out in the industry. People are leading with slasher income tax bills. Slash your capital gains tax bills. I don't think that's the right way to think about this. Right.

[David]

And you don't want to have the tax tail wag the dog. That being said, two, two things I'd push back on. One is no matter how bullish you are on a SpaceX or Anthropic or OpenAI, it's still single asset exposure. All things being equal, if you get the same exposure in a basket, that's going to be optimal.

[Chang]

Absolutely.

[David]

And two is the thing that I love about the strategy is unlike a strategy, say an opportunity zone where you're buying a home sometimes in the middle of nowhere and it might be a dead asset, you're actually investing into the S&P 500 MSCI and these kind of things. So it's stuff that you should have in your portfolio. Now I'm 90% private, so I have much more private exposure. And some of that has just been because of my career and past decisions. I think long term I want to be more 60, 70% private. But there's still that other 30, 40%. You have to put it somewhere. Why not put it into something that's giving you both returns and also tax alpha?

[Chang]

I totally agree with that sentiment and I think what I'm saying is before doing it, investors can be very thoughtful about things like manager selection, strategy implementation. There's just been an explosion of these products, right. And every asset manager, fintech, startup, hedge fund seems to be rolling out some variation like pick and choose that carefully. And you know, to your example of opportunity zones, I remember seeing when these were first rolled out in like roughly 20, 21, and anytime an area or geographic region got labeled an opportunity zone, those real estate assets got bit up. And then we had investors piling in because they were like, oh, amazing, I don't have to pay taxes on my capital gains. And then they were buying assets at overpriced valuations. And now when we look back like six, seven years, some of them are underwater on those investments, right? And it's like, so you've let the tax tail wag the dog here. And so, you know, back to my point, it's like, yeah, it's, we don't want to be picking this long short stuff just to do it for tax reasons. You really have to look at the pre tax alpha.

[David]

I still think it's under invested and I hate to have my listeners pay too much on taxes. So manager selection is really important because you have this, what's called a tracking error. So if the S&P 500 retail returns 10%, there may be a tracking error of 8% in the more high octane version of the tax house harvesting, meaning one standard deviation, 18% to 2% and of course two standard deviations, then you could be down 6% even when the S&P 500 is at 10%. So manager selection is really important. What else is important?

[Chang]

The operational aspect is super critical. My heuristic for this is how long has this firm been in business? Because you want to be working with firms when you're long 300% short 200% on a basket of 15002000 stocks, there's a lot of stuff moving around. You want to make sure that firm has navigated all sorts of Volatile markets. Right. Choppy things, you know, spikes in volatility. And so to trade all those efficiently. And some of these firms are now running, you know, thousands of these brokerage or SMA accounts across their platform. Are they set up operationally? Is there the risk management? Right. The trading execution? Can they manage all that smoothly and efficiently? Because a lot can break and go wrong, you know, in these shopping markets.

[David]

So what about fees? Are they consistent across the board?

[Chang]

It's a really interesting topic because it's timely as well. One of the custodian banks, you know, a while back announced that they were going to hike the fees because, you know, there's when you go long, you have to borrow to go long and then when you go short, you get a short fidelity. Yes, correct. Yeah. And so those changes in the fee structure, right, they permeate when you're long 2x3x on the long side, short 1x2x on the short side, those get amplified. And so being mindful and understanding, well, what's my long margin costs, my short financing rebate, obviously there's the manager's expense ratio or management fee to run the strategy as well. All of those things should be taken into consideration.

[David]

What are managers, the top managers charging?

[Chang]

It depends on the tracking error, you know, but roughly something for like 45 basis points to 200 basis points for different variations of these strategies.

[David]

Carry.

[Chang]

No carry.

[David]

Yeah. So fairly reasonable. And Charles Schwab just lowered their minimums.

[Chang]

Yeah, that's right. And so to run some of these strategies, the minimums have actually been halved across some of the variations on Schwab relative to what they were previously on Fidelity.

[David]

Yeah, and for our middle class and lower middle class gps maybe that have half a million dollars to invest in these kind of strategies, are there ways to access the high octane versions of this with lower minimums and if not, are there ones coming on board?

[Chang]

There's some firms out there that do a really great job. I wouldn't say, you know, they're super accessible at like, you know, the tens of thousands of dollars. But you can certainly find firms that were all will launch one of these strategies for say 500,000 account size minimums

[David]

and they're still able to lever 300.

[Chang]

And it'll depend on the firm's comfort level. Some of them will say, okay, if you want to run the 300, you know, long 200 short, you need at least a million or a million and a half. But these are all kind of one off discussions. You can get into these strategies for you know, as low as tens of thousands of dollars with some of these providers. Yeah.

[David]

So that's tax house harvesting. That's obviously extremely sexy and extremely relevant today. But there's also family offices are now telling me they're doing this for W2 income and lowering their management fees. And. And it's less common of a thing, but it's now it's becoming the next big thing in the space. Tell me about that.

[Chang]

It's a topic near and dear to my heart. And spicy too, a little bit. Right.

[David]

None of these players that we've talked about before will ever jump on the podcast. They've told me because it's just so politically sensitive.

[Chang]

Yeah. And I'll share my understanding of how this stuff works. Right. And I think it goes back to like, high level, like, you know, more structural concepts. And I'll give you an example. So like, you know, Bill Gross, Incdes, Pimco, you know, everyone was trading bonds, buy and hold, and you click the coupon, you put the bond in your drawer, and you forget about it. Right. So he started doing things like, well, hey, let's actively manage these bond portfolios. Then he started doing derivatives because he realized, well, derivatives are a very capital efficient way to express certain exposures. And by doing it that way, I have other stuff left over that I can actively manage and add some alpha or some outperformance. Right.

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[Chang]

So Pimco has a, you know, suite called Stocks plus where S&P 500 futures. You put say $2 down, you get $10 exposure. The remaining $8 you can actively manage. Take some credit duration, convexity, risk. Right. Add some outperformance right on the bond market. So this idea of that's portable alpha. Portable alpha, yeah. And it's the idea really is using derivatives to express economic exposures. Investment thesis versus the cash version. Right. And so that falls into different ways some of these portfolios are built. For example, let's say I were to run an equity long short hedge fund. I might rather than say I'm going to buy cash equities. Long or short cash equities. That's very tax inefficient.

[Sponsor/Advertisement Voice]

Right.

[Chang]

I'm going to have a ton of trading turnover, capital gains realized. What if I used equity link swaps or notional principal contracts? These derivatives have different tax treatments under the Internal Revenue code versus your classic cash equities. And it's precisely because of those tax treatments you're going to produce a very different tax realization profile of the hedge fund than if you were doing it with the cash stocks or bonds. And then the other thing kind of that hinges on this stuff is that these hedge funds have to be trader hedge funds versus investor hedge funds. And it's these trader hedge funds that are allowed to pass through things like management fees, performance fees as well as realized losses to the end investor. I've kind of read through some of the literature around this and it's super wonky and in the weeds. But you know, the short of it is, you know, as an investor in a trader hedge fund, you know, the investor gets to consider themselves an active participant which lets them pass through those losses on the K1 to their tax filings.

[David]

So let's put it down in brass tacks going back to our GP. Yeah, he or she has $500,000 in management fees going in in a year.

[Chang]

Yeah.

[David]

Let's say they just throw it all into one of these Products, how much could they decrease their W2 income?

[Chang]

And again, there's so many like, but that there's this. So it's like, well, first you have to be a qualified purchaser. Right. And then you have to make sure that the minimum amount you're investing works. With the hedge fund, the minimums might be quite a bit more than 500,000. And then you got to have the conversation with your tax advisor and say, hey, I want to do this. Like, yeah, do you. I'm not just going to go shoot from the hip on this. But assuming all those things. Thumbs up looks good.

[David]

And those things, again, are minimums. Qualified purchaser and your CPA signs off.

[Chang]

Yeah, has to. I mean, I would say everyone should, you know, dig into this stuff, have the conversation with the tax advisor.

[David]

And by the way, on the CPA part, you get the K1 from the firm and you send it to your CPA before you invest. That's the best practice. If I had, if I gave this to you at end of year, what would you do?

[Chang]

Well, that's exactly it. Right. So you want to talk to the CPA beforehand and, you know, on occasion, maybe the managers will be able to provide you with a prior K1.

[David]

And then the decision is, do I change the strategy or change the cpa?

[Chang]

Yeah, exactly. And then it's, you got to spend time with your CPA and say, well, here's how, you know, I understand this works. You can look here for this number. It should tie out to that number.

[David]

In the legal field. You could get legal opinions.

[Chang]

Yeah.

[David]

And sometimes you just get a law firm to sign off on a legal opinion to lower your tax liability or the risk that you would get some special penalties and things like that. Is there the equivalent of that for cpa?

[Chang]

Absolutely. I mean, whether it's your tax attorney or your tax advisor slash cpa, like, this is the kind of stuff that you want to get really buttoned up before you start investing in strategies.

[David]

And what does that mean? That just doesn't just mean them filing it. That means them writing some kind of opinion.

[Chang]

A lot of firms won't actually extend the opinion because then they're kind of, you know, carrying some liability. And part of where we got comfort with it is, you know, we're working with, you know, some of the most sophisticated, largest hedge funds out there, and we spend a lot of time with them. They publish a lot of great research, you know, and, you know, things in papers and white papers, et cetera. And when you read through that, it's like, okay, this was well thought out, well constructed. We're not doing it for just that W2 deferral. We're doing it for investment reasons. Right. This is going to build a better asset allocation for us overall.

[David]

And for the purpose of this podcast, we're not investing anybody's money. So we could, we could talk about the. There's a differentiation there where one is the tax rationale and one is actually why you're doing something and why you're investing into something. One of the interesting things about the specific strategies is some of the firms that I think are more de risk than others are the ones that offer this to non taxable investors as well. So you could invest in the exact same strategy that the non taxable investors are investing in and that builds this mosaic of information of it being a legitimate strategy. Because non taxable investors are also investing in this.

[Chang]

Absolutely. Equity, long, short hedge funds, managed futures, hedge funds, or trend following hedge funds. These are all strategies that will importantly add diversification to stocks and bonds. They're going to help you build better, more robust portfolios. To your point, they're very commonly used by institutional investors, pensions, family offices, foundations, endowments especially, many of whom are tax exempt.

[David]

When it comes to how legitimate the tax strategy is, how much of it is about the strategy and how much of it is about the manager as an individual investor.

[Chang]

Yeah, I think it comes down very strongly to the manager.

[David]

You could have, in theory, the exact same execution of a strategy from two different managers. One of them has a taxable and non taxable. That's okay. Another one is just building this niche strategy around the taxable investor. And the IRS might not like that.

[Chang]

It depends, because you do see products out there that are incredibly aggressive. And it does feel like, hey, this, I don't know, like, I don't want to be the one interpreting IRS code, but it feels like it's very aggressive. Yeah. And so, you know, where we tend to land is, well, let's be conservative in how we think about this.

[David]

What does that mean, being conservative?

[Chang]

For example, let's take a look at, you know, the last three or five years of the tax profile of this hedge fund. What did it look like? Right. If it was totally egregious, where it was throwing off like insane amounts of some, you know, tax profile where the numbers just stick out. Maybe we should wait and see a little bit. Right. But if it's like, okay, you know, this is, let's say I'm just making numbers, but like, hey, this realized 25, 30% ordinary losses last year, but we swapped that out for a long term capital gain. Right. And I should caveat and say you're not getting rid of taxes, you're not throwing away your tax bill, you're sort of rearranging the deck chairs.

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Right.

[Chang]

You're shifting something from ordinary loss to long term capital gain. Right. Maybe there's some short term loss as well, but you're kind of moving things around and it's because of the derivatives expression of these economic substance ideas. That's why you have this differentiated tax.

[David]

Going back to this example, you have 500k in management fees. You put it in, let's say you hit the minimum, your CPA is good with it, you're a qualified purchaser.

[Chang]

It's going to vary by fund and year and it's never predictable.

[David]

And we've talked about the main players on the tax loss harvesting side. Who are the main players on the tax aware hedge fund side?

[Chang]

AQR's got a great suite, Quantino's got some great things going on. Two Sigma just came to market, you know, last year with something. I think Millennium's jumping in the fray as well. So there's a number of these Gotham and so it really gets in the weeds. But like, you know, we took a close look at, for example, Gotham has a product that is looks and feels like a hedge fund, but it sort of runs more like one of the long short SMAs. It's just in a GPLP vehicle. Right. It's a private fund. So it's kind of like a hybrid of both now. Right.

[David]

It's important to table set again, although I find this topic very interesting, it's not intrinsically interesting. It's interesting for a reason. We talk about on this podcast many times how difficult it is in both the private, but especially in the public markets to generate alpha via skilled trading. I've also started to get pitched other tax aware strategies in real estate. We've had a couple of people talk about that and also crypto seems to be a very natural place for this because of the volatility. Have you seen any credible parties in the crypto side of tax aware strategy?

[Chang]

I have not seen anything credible on the crypto side. But on the other side you mentioned real estate, solar projects. We went pretty deep on this stuff and I don't know if you looked

[David]

at it at all. Tell me more.

[Chang]

It was crazy. Basically you can invest in a solar project and then you get all the tax benefits. You get to like pull your depreciation forward, you Know, you get a huge, you know, income tax offset. You can even lever your investment up going in there. But the where we got stuck was one, it's super complicated. You really have to get comfortable. You know, we spend time with like, you know, tax folks, legal folks, and it's hairy. And then not only that, you have to be an active participant, meaning you have to spend 100 hours on the solar project site. So you're really putting on a hard hat and a safety vest and spending 100 hours of your year.

[David]

Like it's like the real estate professional.

[Chang]

It's similar to that. Exactly.

[David]

And what, what were the stated benefits of that?

[Chang]

Well, just the tax benefits were incredible. It was written up in the one big beautiful bill act. Right. The administration is really incentivizing people to fund solar projects and so they created these incredible tax benefits. I think the problem is one, sourcing the deals is not, it's pretty tough. Two is are you ready as an investor to go through the rigmarole of 100 hours on site? And it's not just reading research reports. You actually have to show you're on site doing something active.

[David]

Michelle del buno. Yeah, CIO of a 16 perennial. He said that his benchmark for everything on the taxable side is now this tax loss harvested index. And seems like that's the new standard for taxable investors. You are more plugged in. You're literally co hosting a conference on this very topic with a mutual friend of ours. What do you see coming down the pipeline and what's most exciting to you?

[Chang]

I'm going to go the other way in terms of what I see coming down the pipeline. I think I'm not excited by what's coming down. I see a lot of firms jumping in the fray because they see all the assets flowing in. So you sort of have this proliferation of projects.

[David]

I think quintino went from 1 to 30 billion aum within a calendar.

[Chang]

Yeah, blink of an eye. And it's, you know, these strategies have attracted so much in assets. I got shown a strategy last week from a friend of mine. It was basically tax loss harvesting. They're using ETFs. It's a basket of 11 ETF holdings. Very large, well known, you know, asset management firm. They are basically harvesting losses and replacing the ETFs with similar exposures. They charge as much as 2.95% on the management fee. And you look at the track record, historical returns, it's underperformed by roughly 2.95% to the index. And sure, you get Losses. But it kind of begs the question like why would I do this? Right. Are people doing it just for the tax loss harvesting? And so a lot of folks are coming to market with these products and you see the marketing, you see the advertising, the stuff on their websites, all they're touting is the tax benefit. There's really no economic substance behind why you would even implement these strategies. And that kind of concerns me just

[David]

that as an investor you want to make sure that your money's going towards something productive. Also as a tax position, it's a dangerous tax position if there's no substance.

[Chang]

Exactly. And so you know, and that's because

[David]

the tax law is set up in such a way that you can't just do this just for the tax.

[Chang]

Exactly. The economic substance doctrine. Right. It's one, is your economic position meaningfully changed? And two, if it weren't for the tax benefits, like would you still do this? Right. And it's like if you're starting with a conversation at like taxes, that's probably the wrong approach.

[David]

I know some of these indexes are S&P 500 and MSCI. Is there case law on that? Is that, is that a totally defensible position in terms of like I would have invested in msci.

[Chang]

The defensible position is that, you know, if you are taking a loss on an asset and you're realizing it, you know, like that is booked as a capital loss. Right. So there, I don't think there's like a ton of like, you know, variation on how you can define those rules. But to your point. Yeah, I mean I think, you know, for example, some of the MSCI world benchmark long short strategies, they may not even go short because it's harder to source the shorts. Right. Versus like the Russell 3000 you get to work with.

[David]

I was going to go there. That, that's, that's index. It seems like a lot of the tax aware investors are most excited about Russell 3000.

[Chang]

That's right.

[David]

Why?

[Chang]

Well, it's a very simple reason. You get 3,000 different ones to pick and choose to try to create alpha. Right. You can build more like the quantities of the holdings in the long and short baskets is greater. So there's going to be one, you know, better opportunities to create alpha pre tax and then there's also going to be more opportunities to harvest losses relative to say if you had a universe of 500 stocks like the S&P 500. So that's generally why we see most folks, at least from my, my perspective, offer the Russell 3000.

[David]

You have quite a few SpaceX holders as clients and I'm sure you also have OpenAI and anthropic clients as well. What do you think about this evolving strategy in the public markets of being directly accepted in the indexes? Talk to me about the downstream consequences of that and maybe quantify that if you can.

[Chang]

Well, credit goes to my co founder, business partner, Michael chung. He sourced SpaceX in like 2016, 2017. He saw the opportunity and in the last call it year and a half.

[David]

What was the valuation there?

[Chang]

It's some of the positions we were up 60, 70x versus the most recent post XAI merger valuation. But now we're seeing 2 trillion. Right. Is kind of what people are saying for the IPO valuation. Yeah, it's, it's just incredible to see that. And I think like by the way, I was going to say congrats on, you know, you got an anthropic.

[David]

Thank you. Super hard to get. Thank you. Anthropic, super early SpaceX early. Ish.

[Chang]

Yeah. But back to your question. I mean it's potentially game changing, right? Like previously, if your company went public, IPO, you got to wait like 90 days and then maybe you get included on a, you know, index. The reality is our market structure today is so dominated and driven by passive flows. There's not that many people out there looking at, you know, fundamentals, tolls and valuation and then picking stocks. Everything is driven by passive. You can just think like, hey, if I have, you know, a Target Day fund in my 401k, every dollar I save in my 401k goes in that passive fund, 6, 60 or 70% of it goes into the NASDAQ or the S&P 500 or the Russell. And so those flows are incredibly powerful. And so for a company like SpaceX to say, I'm not going to wait 90 days, I want it by day 15, put me in the NASDAQ 100. Now you benefit from all the money that's sitting in all the NASDAQ ETFs. Right. All those passive flows, they're now forced to buy your stock. And so it's a huge tailwind for the stock price.

[David]

How does that look like order of magnitude? IPO is expected somewhere between 50 and 100 billion. I have no insider knowledge of it. Yeah, let's just say it's 75 billion. How much of QQQ is going to go in?

[Chang]

Yeah, and I, I, I, I can't say either because I think what we're getting at is Whatever that number is, what's the weighting in the index? Right. So I mean, I don't know if it's like 2%, 3% and I, I just have no idea.

[David]

That's the aggregate index amount. And then mo most people are market cap exposed to it. Not equal equally.

[Chang]

Exactly. And you can just imagine like if I'm an ETF that tracks the NASDAQ 100, I have to hold all the positions in proportion to what that benchmark reflects. And so whether or not I like it, I'm going to go have to buy that company. Right. That company is SpaceX.

[David]

Fifteen days after IPO's and then another info. If they get into the S&P 500, at which point does that become priced in?

[Chang]

It's really hard to say. Right. Because I don't think the reality is most equity market investors are thinking through how powerful the flows are. Right. And it's why we see like the Max 7 becoming such a big part of the s and P500. Like you don't think about it, right. The news coming out about the Max 7, I don't see it like that change, you know, that game changing. It's not like they're shockingly outperforming earnings results, but those stocks have slowly trickled up over the last 10, 15 years. And that's driven by a lot of it is the passive flows. Right. This is just a steady drip.

[David]

Funny because people look at the index as S&P 500. Oh, it's up 1%, it's down 2%. They don't think about the obvious thing, which is if those seven stocks are doing really well, that's driving the entire ticker. So they just see this ticker and say, well, this is how the economy is going. Not realizing that it's heavily weighted towards a 7.

[Chang]

That's right.

[David]

What else are you most excited about?

[Chang]

I think everything we talked about so far, you know, it's on the asset side. Some of my more formative years were at Pimco on the debt side and like I love thinking about things like liabilities. It's so funny because like, you know, investors are so price sensitive, they'll say like, oh, you know, it's 10 extra basis points on the investment management fees and they want to like trim that down. But then on the borrowing side, you know, when we borrow, like at least when I borrow, it's, I need to get this line of credit set up. Oh, I need a mortgage, mortgage, whatever it is. And it's sort of done just in Time. And for that reason, you know, you call up your bank, your friendly banker, and you just take whatever price you're given, right? And oftentimes consumer borrowing, whether it's mortgages or car loans, you know, we're talking 6, 7%. If you set up a portfolio line of credit, it's roughly in that range. The reality is if you're thoughtful, you plan out ahead and you're comfortable with options, you know, listed options like spx, you can probably tap into institutional borrowing at or very close to the risk free rate. So we're talking 2, 300 basis points lower, which I get excited.

[David]

Let's maybe give, give an example. Let's say I'm borrowing $2 million against a house. How can you, how can institutions lend you that money?

[Chang]

For example, you might say, hey, I'm going to get a home equity line of credit set up, right? And whatever that rate is, the bank gives me, the other way to think about it is, well, hey, I can do that. Get the HELOC set up, no problem. But you don't have to tap into it. But if you have a portfolio of assets at a brokerage account, right, at Fidelity Schwab, you can do what's called box spread lending. And the reason this hasn't gotten like, it's starting to get really popular in the RA and wealth management world and type circles. Yeah, exactly. It's, it's only like the wonky. Exactly, exactly. It's been used by like institutions, market makers, hedge funds, they do this right? And you tap into the options market. One funny rabbit hole to Gunder. If you Google like Reddit box spread lending, there's all sorts of anecdotes on the Internet about people blowing themselves up because they use the wrong type of options. But the short of it is, you know, you're basically trading a synthetic long and a synthetic short on the same underlying. And if you think about a synthetic long and short, when they cross, the outcome is defined, right? So you can take the other side of the trade where I know exactly what my defined outcome is in terms of what I have to pay back, you know, certain period of time from now. And if you think about how that looks like from a cash flow perspective, it's pretty similar to a zero coupon bond. So you're basically using options to build a zero coupon bond, in which case you are the borrower. The beauty of all this is the implied borrowing rate comes out to be pretty close to the risk free rate, maybe a little bit more.

[David]

How does one implement this you can

[Chang]

call up a number of firms, asset managers, that are coming out and rolling these strategies out for individual investors as well.

[David]

Well, we've spanned the gambit, put 80% of the audience to sleep. The other 20% are very excited. Thanks so much for jumping on and thanks for talking about Tax Alpha. Thanks so much for coming on.

[Sponsor/Advertisement Voice]

Che.

[Chang]

Yeah, thank you so much, David, for having me. This was so much fun.