How deleveraging works in long short direct indexing

Long short direct indexing is built for investors who want to seek additional returns on top of the market while systematically managing capital gains through tax loss harvesting.

But when investors learn leverage is involved, they often have the same follow-up question: What happens when I want to get out?

You might be interested in the strategy, but want to understand the exit before committing. You might worry it works well for years, but then leave you with a large tax bill and hundreds of stocks to manage on the way out. Or you might wonder whether exiting means selling everything, moving to cash, and losing the direct index you spent years building.

Ultimately, exiting a long short strategy isn’t an all-or-nothing decision. It’s a planning process. Below we’ll cover three levers to consider when choosing how you want to deleverage. Whether you want to simplify your strategy or move to a different level of exposure, it’s really about choosing what you want your portfolio to become next. And to help you get there, you can adjust three key levers: time, available losses, and cash.

What does it mean to deleverage?

A long short portfolio has both long and short positions. Long positions are stocks you own. Short positions are stocks you’ve borrowed and sold. Together, they create a leveraged portfolio. For example, in a 140/40 strategy, the portfolio is designed to hold approximately $140 in “longs” and $40 in “shorts” exposure for every $100 of net investment. You can learn more about the mechanics in our technical white paper. 

In higher-leverage versions, such as 200/100 and 250/150, the strategy simply turns up the dial on both sides. In these cases, the leverage is sourced from two areas: 

First, the short side involves borrowing securities and selling them short. To close those positions, you need to buy back the securities and return them to the lender.

Second, the long extension also uses financing. Because you own more long exposure than your net capital alone would support, the account uses margin to cover the difference. 

Deleveraging is the process of dialing back that extra exposure. Depending on your goals, you can do this by closing short positions, reducing the margin-financed long exposure, moving to a lower-leverage version of the strategy, or switching to a classic, long-only direct index. 

The difference between reducing leverage and selling the portfolio

Investors often conflate the two paths when they lead to very different outcomes for your portfolio and your tax bill. 

Reducing leverage: The strategy shift

You may decide that you no longer want a long short portfolio, but wish to stay invested in the market. In this case, you aren’t “getting out” of your investments; you’re simplifying your approach.

To do this, you would want to close the short positions and reduce the margin-financed long extension. In the end, you are left with a classic direct index. This allows you to continue owning individual securities directly and keep existing tax lots without the long short structure.

Selling the portfolio: The full exit

Selling the full portfolio is an entirely separate decision. If your goal is to move your money completely into cash, all of your holdings — including the long positions that have grown in value — must be sold.

Selling appreciated stocks will trigger taxable gains. Frec’s system gives you the option to use harvested losses to help offset these gains, though the final tax result will depend on your specific financial situation.

This is why “getting out” of long short doesn’t always mean liquidating your account. In many cases, it isn’t about leaving the market entirely; it’s simply about choosing what you want your account to become next.

	Reducing leverage (strategy shift)	Selling the portfolio (full exit)
Goal	Stay invested but remove leverage	Move entirely to cash
Action	Close shorts and reduce margin	Sell every holding in the account
Result	You keep your stocks in a classic direct index	You exit the market entirely
Tax Impact	Minimized via harvested losses	Higher; all “winners” must be sold

The 3 levers of deleveraging 

Lever 1: Time

Time is your most flexible tool when navigating a transition. If you don’t need to deleverage immediately, a gradual transition allows Frec’s system the room to be more strategic. Instead of being forced to sell at today’s price, the system can choose which positions to sell, which short positions to close, how to reduce margin-financed exposure, and when to trade. This also allows the portfolio to continue harvesting new losses to offset gains created as leverage is reduced.

While time doesn’t eliminate taxes entirely, a planned “unwind” is usually much more tax-efficient than closing everything at once. For example, moving from a 200/100 strategy to a 140/40 strategy over several weeks or months allows for a deliberate transition that captures new tax savings along the way. 

Lever 2: Harvested losses

The second lever is using losses you’ve already accumulated. Long short strategies can generate significant tax losses over time, which can be carried forward to future years. If you have enough of them available, Frec can use them to offset gains created during the deleveraging process.

The tradeoff is that using losses to exit the strategy means they won’t be available to offset gains from other areas of your life, like selling crypto or a home sale.

Lever 3: Cash

Adding cash is often the least intuitive lever, but it can be very impactful. 

When investors add cash, they assume their cash “disappears”, but another more helpful way to think of it is a transfer of value. You aren’t paying a fee; you are using cash to buy back the borrowed portions of your portfolio. The money leaves your bank account but stays in your portfolio. You end up with a larger, simpler portfolio that you own outright.

Here’s an example:

Imagine you start with $100,000 in a 140/40 strategy. After one year, your investments have grown by 15%, bringing your total account value to $115,000. During that same year, the system also captured $26,000 in tax losses.

Now, suppose you decide to switch from your long short strategy to a classic direct index. The 140/40 strategy has approximately 40% short exposure relative to the portfolio value. On a $115,000 portfolio, you would need to deposit ~$46,000 in cash to close the short exposure.

By adding $46,000 of new cash to your existing $115,000 portfolio, your new classic portfolio would be approximately $161,000. You have simply swapped borrowed power for your own capital.

Let’s also assume that closing the shorts would result in ~$2,686 in capital gains. Since you already harvested $26,000 in capital losses, you would still have approximately $23,314 in net harvested losses after offsetting those gains.

Behind the scenes, your cash deposit buys back the borrowed securities to close the shorts. This “unlocks” the cash collateral held by the broker, which is then used to pay off the margin debt that supports the long extension. You absorb those extra stocks into your own name, leaving you with a larger long-only portfolio.

Now you’ve gone from a long short portfolio to a simple, classic direct index portfolio plus $23,000 in leftover losses you can use for future capital gains. 

This example is hypothetical and for illustrative purposes only. It does not represent actual client results. Individual outcomes will vary based on market conditions, tax situation, and portfolio composition.

Tax impact of closing shorts and rebalancing

While using harvested losses can significantly offset the cost of deleveraging, there are still final tax considerations to keep in mind. The process of closing out short positions and reducing your margin may trigger capital gains. Fortunately, as we saw in the 140/40 example, having a bank of harvested losses can help neutralize these gains.

Beyond the initial transition, your portfolio may also need a rebalance. This happens because the extra stocks you absorbed from your long extension might have been tilted toward specific factors like quality or value. To ensure your new, larger portfolio closely tracks your chosen index, Frec may need to sell some of those extra shares and buy others. This rebalance can create additional gains depending on your specific holdings and market conditions at the time.

The main takeaway is that your cash doesn’t disappear — it becomes a part of your portfolio. By using it to close shorts and reduce financing, you are simply transitioning your account into a larger, classic direct index while maintaining as much tax efficiency as possible.

How Frec makes deleveraging easier to evaluate

You shouldn’t have to guess the tax impact of your decisions or wait until tax season to find out. On Frec, you can review different ways to deleverage and choose the path that best fits your goals. 

For example, you may choose to deleverage more tax-efficiently over time, or you may choose to close short positions more quickly if speed is your priority. The platform will also show you how adding different amounts of cash changes the outcome of the transition. 

Remember that the tax outcome still depends on your situation, and it’s worth consulting a tax advisor. But having these options visible in one place can help make a lucrative decision feel more straightforward.

Example paths

Deleverage over time, and then use cash to finish

One way you can deleverage is to use a hybrid approach. You can start by reducing leverage gradually over a defined period, allowing the portfolio to continue harvesting losses to offset gains along the way. Then, near the end of the unwind period, you can contribute cash to close any remaining shorts or “absorb” the long positions instead of selling them.

This approach may work well if you don’t need to exit immediately but still want a clear, manageable path. It may also be beneficial for investors who expect future liquidity such as cash from a bonus, equity compensation, tender offer, real estate sale, business sale, or an investment distribution. You can start the process today, then use the future cash to finish the transition.

Moving to a lower-leverage strategy

Deleveraging doesn’t always mean leaving the strategy completely. For example, you may start with a higher-leverage version of the strategy (like 250/150). Later, you may decide that you want to switch to a lower-leverage (like 140/40).

The same basic framework of time, losses, and cash applies here too. Whether you’re moving from 250/150 to 200/100, from 200/100 to 140/40, or from any long short to classic direct indexing, the process is built to be flexible as your needs change.

What happens to fees as you deleverage?

Post-tax financing cost is gross financing cost minus tax deductions from financing expenses using a 40% marginal tax rate. Actual after-tax costs depend on individual tax circumstances, consult your tax advisor. As a percentage of total assets, pre-tax financing cost is 0.38% for 140/40, 0.95% for 200/100, and 1.425% for 250/150.

As you reduce your leverage, your costs generally decline in two ways: 

• Financing costs: This scales down automatically. As you use less margin to support your long extension, your financing costs will decrease.
• AUM fee: This works differently from financing costs because it is tied to the strategy level. As the account moves from one leverage to another, the AUM fee steps down. For example, a 250/150 account has a 1.30% annual AUM fee. If the account is partially deleveraged to 225/125, the investor would pay financing costs based on the lower amount of margin being used, but the AUM fee would still reflect the 250/150 tier. 

Once the account reaches the 200/100 strategy level, the annual AUM fee would step down to 1.00%. If the account later moves to 140/40, the annual AUM fee would go down to 0.50%. If you transition into Classic Direct Indexing, the fee would go down again based on the applicable classic direct indexing fee, such as 0.09% for the S&P 500.

In short, fees generally decline as leverage declines, but not every fee declines in the same way. Financing costs scale down with margin usage, and AUM fees drop as the account reduces leverage.

What’s next?

When considering a deleveraging plan, it comes down to three simple questions:

1. How much time do you have?
2. How many harvested losses are in your “bank”?
3. How much outside cash are you willing to move into the portfolio?

The Frec team is happy to run a personalized portfolio analysis to help you make a plan. Just book a call or email us at help@frec.com. 

This paper covers deleveraging from long short strategies specifically. If you are considering other exit options, such as transferring assets to a Frec self-directed account or an external brokerage, certain costs and limitations apply.

The long short strategy utilizes margin loans and shorting of stock, both of which increase your investing risk. This handbook is for information purposes only and not intended as tax or investment advice. Frec does not provide tax advice, and you are encouraged to consult with your personal tax advisor.