295 | Understanding Leverage, Short Selling, and Active Trading in Tax-Aware Long-Short Strategies (Part 1 of 2)

[INTRODUCTION]

[00:00:34] Hilary Hendershott: Well, hey, Money Lover. As you know, I’m Hilary Hendershott, CFP^® and founder of Hendershott Wealth Management^®. For over 25 years, I’ve helped high-net-worth investors grow and keep more of their wealth with practices grounded in evidence, integrity, and proactive tax strategy.

[00:00:51] Today, I’m sharing the audio from a 7-part video series I recorded about how a few relatively common investment tools you’ve been taught to fear—like leverage, short selling, and active trading–come together in our tax-aware long-short strategy to create tax alpha–and how this strategy can make a 7- or even 8-figure difference for suitable investors.

[00:01:17] That does mean millions, or even tens of millions of dollars in additional wealth.

[00:01:22] By the way, you’ll hear me talk about tax alpha a lot in these episodes. Tax alpha means higher net returns that don’t come from investment performance, but from smart tax strategy.

[00:01:34] I’ll air the audio from the 7-video series in just two parts here on Love, your Money^®– and if you prefer to watch? Well, head on over to my YouTube channel at youtube.com/@hendershottwealth.

[00:01:48] Now, before we go any further, I do want to mention that my team does not prepare taxes, and the clients with whom we use the strategies inside our Ultra Tax Efficient Wealth Management℠ suite do need to have a professional tax preparer–that’s a CPA or an EA. We collaborate with that professional to make sure the tax-aware planning we do from our side is incorporated into our clients’ returns.

[00:02:09] We’re starting with one of the most misunderstood tools in finance: leverage.

[00:02:15] What is it? When is it smart? When is it dangerous? And how can you use it to build wealth—without putting your financial life at risk?

[00:02:26] Financial leverage is when you use borrowed money—instead of your own—to invest or make a purchase. It shows up everywhere, and you’ve probably used it in your own life already. For example:

• A mortgage to buy a house,
• A loan to start a business, or
• Margin in an investment account

[00:02:43] The idea is simple: If the total return on what you earn is greater than the cost of borrowing, you come out ahead.

[00:02:52] But—and this is important—leverage multiplies everything. Gains, yes. But also losses.

[00:03:00] Not all leverage is created equally, so let’s talk about what makes the two types different–starting with low-risk leverage, such as:

• A fixed-rate mortgage on a home you can comfortably afford,
• A business loan backed by predictable cash flow, or
• Using leverage in an investment strategy that is rules-based and risk-managed

[00:03:20] If you’ve ever taken out a mortgage, you’ve used leverage. Consider a 30-year fixed mortgage on a home you can comfortably afford…

[00:03:28] A $200,000 down payment on a $1 million home uses 4x leverage, meaning you’ve invested $200,000 of your own money and borrowed the remaining $800,000. If the home goes up in value, you benefit not just from the growth on your original $200,000, but on the full $1 million asset. If the value of the home declines, the loss applies to the full $1 million as well.

[00:03:57] A 10% decline on a $1m asset is $100,000 – but $100,000 is half of your original $200,000. And most of us don’t think twice about taking out an 80% mortgage. But that’s leverage—it magnifies both gains and losses.

[00:04:14] To be clear, an 80% mortgage is commonly accepted as low risk. However, if on the same property, you were to put down only $50,000 and borrow $950,000, that is a high-risk mortgage–both for the borrower and the lender.

[00:04:30] In the investment world, leverage can be either high risk or low risk. Investors can borrow from a custodian like Fidelity or Schwab using their existing portfolio as collateral. That borrowed capital can then be used to purchase additional stocks.

[00:04:45] If those stocks simply mirror the holdings of the existing portfolio, that’s high-risk leverage (think of it like taking your 80% mortgage to a 95% mortgage). If the investor buys securities that are very different from what they currently own, that’s low-risk leverage. That would be like adding a bond fund to your S&P 500 index fund portfolio.

[00:05:08] Low-risk leverage gives you access to more resources. You’ll pay the interest rate to borrow, and you are taking some risk, but it’s very manageable risk.

[00:05:17] The most risky kind of leverage amplifies your existing exposure, which means when things go wrong, they can go really wrong.

[00:05:26] Other types of high-risk leverage include: Borrowing against your home to invest in crypto, or taking out margin loans to chase short-term stock swings.

[00:05:36] If the investment tanks, now you don’t have your original investment, but you still owe the money. That’s where things get dangerous.

[00:05:46] It is worth repeating: Leverage works like a multiplier. If things go well, your gains are bigger. If things go badly, your losses are bigger.

[00:05:55] Used wisely, leverage is a wealth-building tool. Used carelessly, it’s potentially a wrecking ball.

[00:06:01] For example, let’s say you hold a large position in your company stock but you don’t want to sell it and trigger a big tax bill. By using leverage—borrowing against that position—you can access liquidity today, without having to sell.

[00:06:14] But this is like taking your mortgage from 80% to 95%. Your company stock, and your career, are likely to move together. By adding leverage, you double down on this risk. Do you really want to increase the odds that your job and your portfolio tank at the same time?

[00:06:31] There’s a better way, and that’s using the tax-aware long-short strategy within our Ultra Tax Efficient Wealth Management℠ offer.

[00:06:38] Prudent leverage is when you use the RIGHT AMOUNT for the RIGHT PURPOSE. So, we’ve all seen what happens when leverage goes bad—think about the 2008 housing crisis and the collapse of Lehman Brothers, or, years later, the collapse of Silicon Valley Bank.

[00:06:52] In both cases, the firms that ended in disaster borrowed heavily—in Lehman’s case, $32 to $1, and in Silicon Valley Bank’s case $12 to $1—to amplify their market bets. And when those bets failed, so did the banks.

[00:07:10] In contrast, our tax-aware long-short strategy, powered by AQR Capital Management through its Flex SMA product, borrows between $0.50 and $2 for every $1 of client equity. That’s half the leverage of a typical mortgage. It’s like putting down a 50% down payment.

[00:07:30] But more importantly, we’re not using that borrowed money to take bigger risks. We’re using it to diversify and generate tax alpha–which means higher net returns not from investment performance, but from smart tax strategy. And without adding more market exposure, so that people like our hypothetical client, Julie, can diversify $12M in concentrated stock without the $4M tax bill that significantly limits her wealth potential over time. You’ll hear more about how as we progress through this series.

[00:08:03] The bottom line is that leverage isn’t inherently good or bad—it’s a tool. The key is using it wisely, within a broader strategy that’s aligned with your goals and risk tolerance.

[00:08:14] Now, I want to introduce you to a very specific kind of leverage employed in the tax-aware long-short strategy we use powered by AQR’s Flex SMA: It’s called “market-neutral tax-aware long-short.”

[00:08:30] That’s a lot of words. I am going to explain them all clearly, and this will all be very digestible.

[00:08:36] The core idea? You can use leverage to buy additional stocks without increasing your exposure to stock market risk. In fact, you can use it to achieve that tax alpha I mentioned: where you earn higher net returns that don’t come from investment performance, but rather from smart tax strategy—which is exactly what tax-aware long-short does for you.

[00:08:56] Not all leverage is created equally. And today, I’m going to show you why.

[00:09:00] Let’s start at the top.

[00:09:02] Like we discussed earlier in the series, leverage usually means using borrowed capital in the hopes of increasing returns. Most people think “leverage” means “more risk”– and they’re right when leverage is used in the usual way. But market-neutral leverage works differently to keep the added risk tolerable–and depending on your overall strategy, it can even REDUCE risk.

[00:09:23] “Market-neutral” means you’re not using that leverage to bet on whether the market goes up or down—you’ve removed that exposure entirely.

[00:09:31] In the tax-aware long-short strategy we’re describing here, your core portfolio is used as collateral to borrow stocks. Then the account manager opens two sets of positions in a separately managed account:

• Long positions that benefit if stocks go up,
• and short positions that benefit if stocks go down.

[00:09:51] Because you’re long and short in roughly equal amounts, the market risk cancels out–and that’s the key: leverage is primarily used here to generate tax outcomes, not to chase performance.

[00:10:04] That’s what makes it market-neutral: your portfolio doesn’t become more sensitive to market swings.

[00:10:09] Instead, it generates activity and losses that can be used to lower your tax bill—without changing your overall market exposure or resulting in “real world” losses. You really can have profits from your investments, with losses only on your tax return.

[00:10:26] Let’s break market-neutral leverage down into its components, first looking at the “long” part of the long-short strategy.

[00:10:32] This part of the strategy looks and feels a lot like a traditional investment portfolio. When you “hold a stock long,” you own it and earn returns when the market goes up. That’s the “normal” way to own a stock.

[00:10:46] In a long overlay, you use your core portfolio as collateral to borrow money from a custodian—like Schwab or Fidelity—and buy even more of those stocks.

[00:10:55] That increases the size of your portfolio, and with it, your exposure to market gains and losses.

[00:11:01] When the market goes up, the long overlay rises with the market–in fact, it’s designed to slightly outperform the broad market, and you, the investor, reap profits which remain unrealized–meaning unsold.

[00:11:14] When the market goes down, the long overlay falls in value. Here, the losses are harvested to provide tax benefits without affecting the core portfolio.

[00:11:24] It’s like doubling down on your investment, and it’s probably sounding a lot like that high-risk leverage we warned you against earlier in this series—but in this case, you’re doubling down on the upside and simultaneously neutralizing the new, added risk.

[00:11:41] You neutralize the new risk with the short overlay–which I’ll tell you about next; the short overlay cancels out the extra risk from those new, borrowed, long positions.

[00:11:51] Now for the short side. This is where the real magic happens–where the strategy gets smarter, and the most valuable tax efficiency shows up.

[00:11:59] Along with the long overlay, the manager borrows stocks to short them. That means they sell those stocks with the intention of buying them back later—ideally at a lower price.

[00:12:10] If that happens, the difference is profit—profit that offsets losses elsewhere in your portfolio when the market goes down.

[00:12:18] However, because short positions tend to lose money over time (by design, because the stock market tends to go up over time), that’s where we experience the real tax alpha magic: those “losers” generate large, consistent tax losses that we can harvest and use to reduce your tax bill.

[00:12:40] So, we are systematically shorting to keep those long positions we bought with borrowed money from adding market risk to your portfolio.

[00:12:52] Also, the system is designed to find stocks that statistically underperform—that’s one of the ways the strategy is designed to produce a small bonus return.

[00:13:01] This is how we can intentionally create tax losses even when markets (and your account values) are up.

[00:13:10] So, now you’ve got your core portfolio, along with an overlay, with two parts consisting of:

• Long positions that profit when the market rises and produce harvestable losses when the market falls; and
• Short positions that profit when the market falls and produce large, consistent, harvestable tax losses to reduce your tax bill when the market rises.

[00:13:34] The combination is what’s called a long-short overlay.

[00:13:38] Even though we’re borrowing to make these purchases, the positions are systematic,  diversified, and balanced—we’re not making big bets, or trying to outguess or time the market.

[00:13:50] But in any market-neutral investment, you are making a small bet–that the long positions outperform the short positions. That small bet is the opportunity and the risk. If they do, your portfolio makes a little more money.

[00:14:04] Of course, in a diversified portfolio–with hundreds of stocks–this is a small bet with small risk.

[00:14:10] The goal here is to capture small, steady returns without disrupting your core investments–all while getting significant tax benefits.

[00:14:21] And no matter what happens in the market, this overlay gives you tax losses without comparable portfolio losses.

[00:14:29] We’ve truly never seen a strategy be able to produce tax alpha like tax-aware long-short, and it does it in both the long and short overlay–no matter which way the market moves.

[00:14:39] Let’s walk through that one, one more time.

[00:14:42] With tax-aware long-short working for you, when the stock market goes UP in value:

• The long overlay rises with the market. Again, it’s actually designed to slightly outperform the broad market–and you, the investor, reap profits which remain unrealized.
• When the shorted stocks rise in value, the short overlay produces losses which roughly offset the gains in the long overlay. These losses are realized, creating tax benefits without portfolio losses.

[00:15:10] And with tax-aware long-short, when the stock market goes DOWN in value:

• The short overlay increases in value, and you, the investor, reap profits–which are largely deferred.
• The long overlay falls in value, and these losses are harvested to provide tax benefits–again, without portfolio losses.

[00:15:32] This is all facilitated by an account manager in a separately managed account. In our case, we offer the tax-aware long-short strategy through AQR Capital Management’s Flex SMA product.

[00:15:43] This isn’t a strategy you should try to implement on your own.

[00:15:47] I know “leverage” and “short selling” sound risky. And in many contexts—they are.

But here’s why this strategy is different:

• It’s market neutral, so we’re not betting on where the market is headed,
• It’s rules-based, so trades are driven by data, not guesses or emotion,
• It’s highly diversified, with hundreds (sometimes thousands) of positions across sectors, and
• It’s monitored and managed, with ongoing oversight from investment managers

[00:16:13] When done thoughtfully, these long and short positions balance each other out. Your leverage isn’t funding bets that the market will go up or down–instead, it’s positioned to be market neutral and provide tax benefits in any case.

[00:16:27] You’re using leverage—yes—but you’re not amplifying market movements. Instead, you’re creating conditions that allow the portfolio to grow with the market, while harvesting significant losses for tax purposes along the way… and all without adding unnecessary risk or volatility.

[00:16:45] Again, this is called market-neutral leverage, and it’s a key component of Flex SMA’s tax-aware long-short strategy that we offer in our Ultra Tax Efficient Wealth Management℠ suite of services.

[00:16:58] We did extensive due diligence before incorporating this into our services because we’re fiduciaries. That means we’re legally—and morally—obligated to act in your best interest. We don’t roll out new tools lightly, but this methodology passed our evaluation with flying colors, and we have seen how it delivers meaningful and significant tax alpha.

[00:17:20] We’ve seen how it can allow clients to afford their dream beach house AND keep their retirement fully funded at the same time after selling their business for $12 million–instead of slicing off a generous portion of their sale proceeds for capital gains taxes.

[00:17:36] We’ve seen how it can help a client diversify $12 million in Apple stock into a diversified, high-quality portfolio in less than two years–without the $4 million tax bill.

[00:17:50] And we’ve seen how it can increase our clients’ wealth by 30-50% just by them rightfully keeping the money they worked hard to earn instead of handing it over to Uncle Sam.

[00:18:00] Because we know that for our clients, balancing risk and reward isn’t just about numbers—it’s about peace of mind. You deserve to sleep well at night knowing your investment and tax strategy is helping you not just manage your wealth, but maximize it.

[00:18:17] Let’s bring this home.

[00:18:18] We’ve explained the long-short overlay. In the overlay, we’re not trying to outguess the market or swing for the fences.

[00:18:25] We’re pairing thoughtful long positions with purpose-built short positions to:

• First, have you benefit from market growth;
• Second, harvest tax losses without suffering corresponding portfolio losses; and
• Third, give you freedom to decide when and how much tax you pay on your investments.

[00:18:45] This is market-neutral leverage, and it’s leverage done right. It’s not flashy, risky, or speculative–it’s conservative, managed, and integrated into your broader financial plan.

[00:18:56] And when it’s done well, it helps you grow your wealth and pay significantly less in taxes—without increasing your risk exposure.

[00:19:05] If you’re investing for the long term, preserving capital and minimizing taxes works far better than chasing high-risk returns, and for suitable investors, the long-short overlay strategy is designed to do exactly that.

[00:19:21] So, the next time you hear “leverage,” don’t just assume high risk. Ask: What kind of leverage? For what purpose? And how is risk being managed?

[00:19:31] Because in the hands of the right advisor, market-neutral leverage can become a tax-efficient growth engine—not a danger zone.

[00:19:42] Alright, if your eyes have glazed over as I’ve talked about tax alpha or long-short overlay, or the idea of leverage still makes you feel uneasy, I get it–and you’re not alone. These concepts are often misused, misunderstood, or both.

[00:19:59] So, let’s back up now and try a new lens—let’s look at what tax-aware long-short has in common with… farming!

[00:20:05] Because, believe it or not, how we use market-neutral leverage in our tax-aware long-short strategy has a lot in common with a well-run farm. Once you understand that, the idea of market-neutral leverage will feel a whole lot more grounded—and way less risky than you might expect.

[00:20:23] Alright, let’s go to the metaphorical farm.

[00:20:26] Let’s start with something familiar: your core investment portfolio. Within your core portfolio, you own stocks. If you’re like our clients with strategically diversified portfolios, you might own stocks from up to 12,000 different companies around the world.

[00:20:41] These are your long positions–if you own these stocks when they go up, you earn a profit.

[00:20:46] Think of this long-only portfolio—with stocks, ETFs, or mutual funds—as your home farm.

[00:20:53] You own the land, you buy the seeds (which are the stocks), you plant them in good soil (that’s your portfolio), and you wait for the harvest.

[00:21:03] More often than not, the weather is good—markets go up.

[00:21:07] Sometimes you get a late frost or too much rain—markets dip.

[00:21:11] But on average, with enough patience, smart planning, and good practices, you do well, year after year.

[00:21:18] This is your basic, solid investment strategy. No borrowing. No added risk. Just planting and waiting–or in our case, time-tested, diversified investing that grows wealth steadily through compound returns over the long term.

[00:21:33] Now, imagine you want to grow more crops, faster.

[00:21:36] So, you borrow money using your existing farm land as collateral, you lease extra fields, and plant more of the same thing.

[00:21:44] If the weather’s great? Your harvest doubles. But if there’s a drought, a flood, or a swarm of locusts? You’re worse off because you’ve magnified your risk.

[00:21:54] This is traditional leverage—investing borrowed money in more of the same. You get exposure, but you’re also more vulnerable to whatever the market does because it amplifies whatever the market gives you.

[00:22:07] This is the kind of leverage that makes people nervous, and for good reason.

[00:22:11] Used poorly, it can cause you to lose the family farm–and that’s why it’s risky: you introduce more exposure without a safety net.

[00:22:18] Here’s where our long-short strategy flips the script and removes the risk.

[00:22:23] We still use modest leverage to borrow, lease extra fields, and plant crops. That’s our long overlay–borrowing against our home farm–to create additional investments.

[00:22:35] But now? We buy crop insurance, which is like our short overlay.

[00:22:40] If the weather turns or there’s a market dip, the short position is designed to kick in and produce a gain that offsets the loss on the long side–like the insurance payout if your crops fail.

[00:22:52] In a drought, our farm does poorly, but the crop insurance covers most of the losses. If the weather’s good, our harvest doubles. And while we still pay the insurance premium… it’s a tax-deductible expense. Even better, if we plant different drought-resistant crops on the extra land, maybe we actually do okay in a dry year because we’re diversified.

[00:23:15] The actual portfolio leverage implemented in the tax-aware long-short strategy we deploy–via AQR Capital Management’s Flex SMA product–is even better because we are able to realize the losses from the drought for tax purposes while pushing our profits and tax bills off into the future.

[00:23:35] With Flex SMA, you get:

1. A core portfolio that grows over time;
2. Extra return potential and tax alpha from the long overlay; and
3. Downside protection, and additional tax alpha, from the short overlay

[00:23:54] So, while traditional leverage amplifies risk, our strategy buffers it because it’s market neutral. It doesn’t rely on the overall direction of the market to work, with both the long and short overlays either producing gains or harvestable losses simultaneously no matter which way the market’s trending.

[00:24:13] Even though we’re using borrowed money for the long-short overlay–which sounds risky–the risk is actively hedged and managed.

[00:24:20] This isn’t about taking wild bets. We’re using a strategy that produces losses on purpose, and in a way that benefits you on your tax return—and therefore in your bank account–without actually shrinking your portfolio.

[00:24:33] Again, that’s tax alpha: higher net returns that don’t come from investment performance, but from smart tax strategy.

[00:24:42] The Flex SMA long-short overlay trades hundreds (sometimes thousands) of positions, using systematic, rules-based investing, and it’s all designed to produce realized losses that you can use at tax time—while your real-world wealth continues to grow.

[00:25:00] We’re not guessing at market trends, we’re building a diversified, risk-balanced overlay that works with your core portfolio–and we’ve seen this strategy’s ability to:

• Turn a $9M IPO windfall into $20M by almost completely eliminating the tax bill today and allowing that tax savings to compound–instead of running out of money at age 65;
• Save an investor $4M in taxes as she diversifies her Apple and Amazon stock going into retirement, and allow for an additional $240,000 in annual spending for 25 years; and
• Allow a retired couple to draw tax-free income from their portfolio for 25 years–while still leaving a meaningful legacy for their three children

[00:25:49] Implementing a tax-aware long-short strategy in your financial plan is about using every available tool to grow wealth smartly and reduce tax drag–without letting mistakes or natural disasters derail your plan. Just like modern agriculture uses:

• Monitored weather systems,
• Diversified crops,
• Irrigation controls, and
• A little insurance for good measure.

[00:26:14] The borrowed fields with added crop insurance are not about “going big or going broke.” They’re about building that market-neutral long-short overlay to generate significant tax losses that create long-term wealth.

[00:26:27] That’s the kind of thoughtful leverage we’re talking about.

[00:26:31] When you hear “long-short overlay,” don’t think “risky, black box Wall Street hedge fund.” Think: smart farm management: A little borrowed land. A little insurance. A lot of thoughtful coordination.

[00:26:45] That’s how we use leverage to help suitable investors reduce tax drag and build lasting wealth—without risking the family farm.

[00:26:53] If you believe you’re a suitable investor for the strategy–that is, if you have at least $1.25 million in a taxable account–and you want to see whether this kind of strategy is a fit, we’d love to talk.

[00:27:05] Head to hendershottwealth.com/contact and book a 45-minute Discover Call with a lead advisor on our team. We’ll learn about your goals, review your tax exposure, and help you determine whether the strategies within our Ultra Tax Efficient Wealth Management℠ offer–including AQR’s Flex SMA tax-aware long-short strategy–can give you more freedom, flexibility, and peace of mind.

[00:27:33] And if we’re not the right fit, we will point you toward someone who is.

[00:27:36] Now, stay tuned for next week, when we’ll air part 2 of this audio-only version of our 7-video series. In that episode, I’ll explain how active trading is used differently in the tax-aware long-short strategy, and we’ll bring the entire series home by talking about how and why tax efficiency is the key to generational wealth AND lifelong freedom.

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