Key Takeaways
- • Long/short equity funds captured less than half of index gains in 2019 (when the index surged 31.5%) and underperformed in 2018, driving significant investor redemptions from the strategy class.
- • Institutional investors withdrew $44 billion from long/short funds in 2019—the largest redemption volume of any investment strategy—reflecting deteriorating confidence in strategy efficacy and risk-adjusted returns.
- • The rapid adoption of tax-aware long/short strategies has grown substantially through both commingled funds and separately managed accounts (SMAs), creating questions among advisors about systemic market risk concentration.
- • Direct equity indexing and long/short extension strategies face natural performance ceilings; loss harvesting typically plateaus around 30% of invested capital as markets rise and the pool of loss-generating positions shrinks over time.
- • Tax-aware long/short investing requires careful portfolio construction considerations including leverage management, volatility resilience, and alignment with varying risk-return objectives across client bases.
Summary
Long/short equity strategies have faced mounting performance headwinds and investor skepticism through 2019, with the strategy class struggling to deliver competitive risk-adjusted returns relative to passive index exposure. Last year, when major equity indices surged 31.5%, long/short funds captured less than half of those gains. The underperformance extended into 2018, when long/short vehicles also declined more sharply than their benchmarks. This consistent underperformance has triggered a crisis of confidence: investors pulled $44 billion from long/short funds in 2019, representing the largest redemption volume across any investment strategy tracked by eVestment, signaling institutional abandonment of the once-popular approach.
The deterioration in long/short strategy performance reflects structural headwinds that have intensified over recent years. The broad shift toward passive index investing and ETF adoption has compressed alpha opportunities by reducing differentiation between security returns and index composition. As passive capital flows have grown, the opportunity set for skilled short-selling and security selection has narrowed, making traditional long/short alpha generation increasingly difficult to achieve.
Tax-aware long/short investing has emerged as a response to these challenges, gaining substantial adoption among institutional investors and high-net-worth clients managing concentrated positions or significant capital gains. These strategies operate on a core principle: strategically harvest losses to offset gains and improve after-tax returns. Direct equity indexing represents the foundational approach—replacing index fund holdings with individual stock baskets that enable systematic loss realization while maintaining market alignment. However, even these tax-optimized strategies face natural performance ceilings. Loss harvesting typically plateaus around 30% of invested capital as markets appreciate, because the pool of underwater positions shrinks over time, limiting the longer-term efficacy of continuous loss generation.
As tax-aware long/short strategies have scaled through both commingled funds and separately managed accounts (SMAs), advisors increasingly question whether the strategy class has become too large to manage without creating systemic market risk. Rapid adoption brings critical portfolio construction considerations, including leverage management, market volatility resilience, and alignment with varying client risk-return objectives. The convergence of underperformance in traditional long/short strategies, massive investor redemptions, and structural constraints in tax-loss harvesting suggests that the long/short model requires fundamental recalibration to remain viable for institutional capital.
The deterioration in long/short strategy performance reflects structural headwinds that have intensified over recent years. The broad shift toward passive index investing and ETF adoption has compressed alpha opportunities by reducing differentiation between security returns and index composition. As passive capital flows have grown, the opportunity set for skilled short-selling and security selection has narrowed, making traditional long/short alpha generation increasingly difficult to achieve.
Tax-aware long/short investing has emerged as a response to these challenges, gaining substantial adoption among institutional investors and high-net-worth clients managing concentrated positions or significant capital gains. These strategies operate on a core principle: strategically harvest losses to offset gains and improve after-tax returns. Direct equity indexing represents the foundational approach—replacing index fund holdings with individual stock baskets that enable systematic loss realization while maintaining market alignment. However, even these tax-optimized strategies face natural performance ceilings. Loss harvesting typically plateaus around 30% of invested capital as markets appreciate, because the pool of underwater positions shrinks over time, limiting the longer-term efficacy of continuous loss generation.
As tax-aware long/short strategies have scaled through both commingled funds and separately managed accounts (SMAs), advisors increasingly question whether the strategy class has become too large to manage without creating systemic market risk. Rapid adoption brings critical portfolio construction considerations, including leverage management, market volatility resilience, and alignment with varying client risk-return objectives. The convergence of underperformance in traditional long/short strategies, massive investor redemptions, and structural constraints in tax-loss harvesting suggests that the long/short model requires fundamental recalibration to remain viable for institutional capital.
Go deeper than the headline
Research every firm in this story, track the ones that matter and get the daily briefing — free for 7 days.