What’s the role of indices in long/short tax-advantaged strategies? Brooklyn Investment Group’s Erkko Etula joins S&P DJI’s Brandon Hass and Rupert Watts to explore how indices like the S&P 500 130/30 Quality Index are helping address concentration risk and demand for customization inclusive of long-term tax objectives via transparent design.
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Brandon Hass:
How are indices helping market participants address demand for customization, inclusive of long-term tax objectives via transparent design? Hello, my name is Brandon Hass, Managing Director and Head of Direct Indexing and Model Portfolios at S&P Dow Jones Indices. Joining me today to discuss the role of indices in long/short tax-advantaged strategies are Rupert Watts, Head of Factors and Dividends at S&P Dow Jones Indices, and Erkko Etula, Co-Founder and CEO of Brooklyn Investment Group. Thank you both for joining me today.
Rupert Watts:
Pleased to be here.
Erkko Etula:
Thanks for having us.
Brandon Hass:
Sure. So, Rupert, let's start with a question for you. So can you introduce the S&P 500 130/30 Quality Index highlighting things like the construction, the constituent selection, and the mechanics of the long/short approach?
Rupert Watts:
Sure, so the S&P 500 130/30 Quality Index is essentially an index of indices, combining both a long index and a short index. The long index is given a leveraged weight of 130%, whereas the short index is given a negative 30% weight to offset the leveraged position on the long and bring down the net exposure to 100%.
Now, the long index tracks the top 100 companies from the S&P 500 as ranked by the S&P Quality Score, whereas the short index tracks the 100 companies that are lowest ranked by the quality score. And basically, the S&P Quality Score is a composite score and averages out three key metrics, a return on equity, which is a profitability metric, the leverage ratio, which looks at total debt to book value, and then the accruals ratio, which essentially assesses earnings quality.
So, by taking a leveraged position in the 100 companies ranking highly on the quality score, you're taking enhanced exposure to high quality companies. And then on the short leg with the 30% weights, with the lowest ranked companies, you're basically positioning for their underperformance and helping sort of bring down the overall risk of the index.
Brandon Hass:
Makes sense. Thank you.
And Erkko, what are some of the use cases of a long/short strategy like a 130/30 approach?
Erkko Etula:
So it all basically starts from the urgency to generate tax losses, right? So think about an entrepreneur selling their company this calendar year, how can they generate realized capital losses to help offset some of the gains from that sale of the company, right? So that's one use case, literally rapid generation of realized losses.
The second use case is diversification out of concentrated stock positions, right? So think about your Nvidia or your Apple stock that has rallied for a long time. The market value is very far from the cost basis for many investors. How do you diversify out of that concentration risk without paying taxes, or at least reducing the tax bill, and in that case again you can put a long/short extension on top of that Apple or Nvidia stock to generate those tax losses, and those tax losses are then used against the gains as you're selling down that concentrated stock.
And then the third use case is what I would call ossified portfolios, so basically portfolios that have been in tax-loss harvesting programs that frankly just held for a long time. So again, the market values of the individual stocks are very far away from the cost basis, so no matter how much market volatility that you get, you're not going to be able to do tax-loss harvesting to a great extent. So, a 130/30 approach can help rejuvenate those types of portfolios.
Brandon Hass:
Very interesting. Well, thank you both. Lots of good facts there.
And so as we think about the construction and some of the use cases, let's talk a little bit about index performance. How has the index performed historically and what role has the quality factor specifically played?
Rupert Watts:
Sure, so historically, the index has really sort of performed in-line with what you would expect from a quality factor strategy, namely, improved risk-adjusted return, defensive qualities and diversification benefits versus broad benchmarks like the S&P 500. And really the benefits that you would expect from taking an outsized position in high quality companies that tend to be strong fundamentals and relatively higher profitability. Over the long term, which does include back-tested performance, the index has generated an annualized return of 14.4%, which represents a little over 3% annualized outperformance relative to the benchmark, the S&P 500. And that return outperformance has actually come with slightly lower volatility and a better downside capture.
The 130/30 structure as well also gives you enhanced characteristics versus the unlevered S&P 500 Quality Index, over the same period has outperformed the S&P 500 Quality Index by about 1.2% annualized and again, done so with slightly lower volatility.
Brandon Hass:
Wow, those are compelling statistics, appreciate that. And Erkko, how does a long/short tax-advantaged strategy work?
Erkko Etula:
So, couple of things there. First of all what Rupert mentioned in terms of the outperformance of the stock selection, that is very important because in order to construct a long/short strategy for the purposes of tax-loss harvesting, you also need to have the economic substance for the stock selection part. Meaning there should be expected excess returns that come from the stock selection component.
Now, let's think about how this actually works in practice and why it helps generate higher tax losses over time. So there are two things at play there.
First, you can expand the size of the portfolio by putting those long and short extensions on your collateral, right? And so that basically just increases the volume of the portfolio for the purposes of tax-loss harvesting so it's almost analogous to adding new cash in the portfolio in the sense that you get fresh cost basis for the stocks in the long and the short legs. And then the second part which is unique to these 130/30 and 150/50 strategies is the fact that you have the negative exposures through the short leg so again the stocks that were short in the short part of the portfolio are now typically negatively correlated to the market. So the drawbacks of the long-only strategies, where again the market values run away from the cost basis, do not exist to the similar extent in the long/short strategies because as markets generally tend to rally, the short leg of the portfolio helps generate those tax losses.
Brandon Hass:
Yeah, it's really interesting. Let's stick with the stock selection process, for these strategies, why would you select the S&P 500 130/30 Quality Index to underlie the strategy itself?
Erkko Etula:
So, if you think about the various different stock selection methods, you can think about a continuum of techniques from index-like techniques all the way to what I would call pure alpha techniques and everything in between. So the conversation is very similar to the conversation about active versus passive, right, for typical long-only equity managers. Now the advantages of going with an index-based approach stem from the fact that it is fully transparent, extremely well researched, so the rules are extremely clear as to why certain stocks are in the long portfolio versus the short portfolio. And also you can gain low tracking error when you put a tax-loss harvesting overlay on it. So basically for investors that are looking for that full transparency as well as the low tracking error, the index-based approach is the way to go.
Brandon Hass:
Fantastic. Thank you both very much for your insights today. To learn more about the S&P 500 130/30 Quality Index, visit us at the link below. Thank you.
