The tax strategy used by the rich to pay 0% income tax
bloomberg.com
bloomberg.com
[1] "Its experts there couldn’t get their heads around AQR’s innovation"
Where AQR innovates is in the following:
1. Suppose I am invested in my 401k into some sort of active etf. The past 10 years have been good, but I've noticed the performance is struggling lately. If I want to switch managers, I have to sell my stock and thus pay taxes on both the alpha (i.e manager skill) and the beta (i.e what the market did). But I don't want to pay the tax on the beta, I want to stay invested in the market swap my alpha.
2. The 2nd part is where it starts getting sketchy. From point 1 onward, we now want to separate our alpha and our beta. The first step is what everyone does: Leverage. Instead of owning a longly only mutual fund or active ETF, I now do the following: I buy a passive ETF (that behaves like the market) and then a long-short/beta neutral etf/strategy that will give me alpha. So for a 100 dollars invested, I now get 100 dollars of market exposure and then a varying amount of alpha exposure (it can range from 60 dollars in a conservative 130/30 or 100 dollars in a more aggressive 150/50). Key part: We solved the problem in point 1, I don't ever have to pay capital gains tax on my market until I genuinely want less exposure to the market.
3. Now comes the fun part: In a typical rising market, what would happen to our supposedly "market neutral" portfolio? On average, we would expect our longs to go up and our shorts to lose value. I could rebalance by selling some of my winners, but then I would be getting hit with the 35% short term capital gains tax which sucks. So what I do is something different: I don't do anything on the long side, I close out my short, open a new short and then carry forward my losses to the next year. With that, some time later, once I want to sell my long positions because they no longer have alpha, I can do it both using the 20% long term capital gains tax (ideally) and I will have accumulated tax losses from my shorts to further reduce exposure. And ideally I generate so many losses that I can offset a lot of my market portfolio gains.
Tl:dr It's basically pretty serious leverage and using constantly renewed short positions to keep delaying the realizations of capital gain taxes by creating tax losses. If you invest 100 dollars in a fund like this, the dream is that at the end of 10 years you have an 500 dollar portfolio with 300+ dollars of tax loss carry forward. The other fun part is when the initial 100 dollars comes from some sort of taxable event, like a sale business, and this strategy can actually cut taxes on that as well.
Simple example: I have 100 dollars, I go the 150/50 route.
Year one: I make 10 dollars on my main portfolio, I lose 8 dollars on the shortside (realised) and and make 9 dollars on the long side (unrealised).
Year two: I make 11 dollars on my main portfolio, I lose 9 dollars on the shortside(realised) and make 10 on the long side (unrealised).
Result: I invested 100 dollars and at the end of 2 years have 123 dollars. If I sell I have 17 dollars of tax loss carry over, so I pay taxes on 5 dollars worth of gains.
This is a gross simplification but that's the basic idea of it. AQR has an even more egregious product called Delphi Plus (that IMO is gonna eventually get IRS into their office) that can create losses that offset agains your ordinary income.