Long short direct indexing
The long short direct indexing handbook
9 min read
Direct indexing gives investors more control—you own the individual stocks, can customize the index to fit your preferences, and automatically harvest capital losses as they come.
But what if you have an opinion on the market? And what if you have major capital gains?
Traditional direct indexing can fall short here, but that’s where long short direct indexing comes in.
In this handbook, we’ll explain what long short direct indexing is, the mechanics, why it matters, and how Frec is making it accessible to self-directed investors.
If you’re new to direct indexing or need a refresher, check out our Direct Indexing Handbook, then meet us back here.
What is long short direct indexing?
Long short direct indexing, also known as tax-aware long short investing, takes the benefits of traditional direct indexing and amplifies them. Like traditional direct indexing, you own individual stocks rather than shares of a fund, but the strategy goes further by taking both long and short positions to precisely express a factor view while harvesting significantly more tax losses.
The approach works by starting with a core index (such as the Russell 1000) and then layering on additional long and short positions to create a factor tilt. For example, at Frec, portfolios track the Russell 1000, have a 140/40 structure (140% long positions and 40% short positions), and investors can choose to tilt toward value or growth based on their market outlook.
This structure allows investors to express a market opinion while maintaining overall market exposure similar to the benchmark index (more on how it all works in the sections below).
What are investment factors?
Investment factors are measurable traits that help explain how stocks perform over time. Investors can tilt their portfolio towards a factor to express their investment thesis. Some common factors include:
Momentum: Stocks that have recently outperformed, with the expectation this continues
Growth: Companies expected to grow sales or earnings faster than average
Quality: Firms with strong balance sheets, stable earnings, and high profitability
Value: Stocks that appear undervalued relative to their fundamentals (low price to book ratio, high earning yields)
Size: Smaller companies with potentially higher growth rates
At Frec, we use the Barra Global Total Market Equity Model for Long-Term Investors to define and measure these factors. According to our research, customers who choose a growth tilt can expect 0.45% in pre-tax excess return and 3.64% in tax-alpha. Compare this to a value tilt which shows a pre-tax excess return of 0.24% and tax alpha of 3.77%. You can read more about the technical details in our white paper.
Why long short direct indexing instead of long only tilts?
You might be wondering: why not just buy more stocks of a certain factor?
Long only tilts work by shifting weights within your portfolio — you buy more of what you like and less of what you don’t. But there’s a catch: the more you tilt your portfolio, the more you drift from your benchmark which leads to taking on unintended market exposure and risk. Plus, long positions tend to appreciate over time which means fewer opportunities to harvest tax losses after the first few years.
Long short direct indexing aims to solve both problems.
Instead of just extra long to increase your exposure to a factor, we use shorting stocks as an additional tool to reinforce the tilt across the portfolio. This lets you pursue a factor tilt without increasing overall market exposure.
We also apply a beta constraint to the strategy to help ensure that the long and short positions move in sync with the benchmark (also known as a beta 1 portfolio).
How the extensions work
Now that we’ve covered what each extension does, let’s break down how they work.
The long extension primarily supports your factor tilt and is funded by borrowing against your core portfolio. We manage leverage with borrowing caps and use the proceeds from short positions to help fund borrowing costs.
The short extension acts as a tool that both funds and sharpens the tilt, allowing you to express it more fully than you could in a long-only portfolio. Short positions also create more loss harvesting opportunities, especially when the market is up, and can meaningfully improve your after tax returns.
Together, these extensions work to deliver a more precise factor tilt while maintaining market-neutral positioning and maximizing tax-loss harvesting opportunities.
What happens when we short stocks
Frec manages the shorting within your portfolio automatically. Here’s how the process works behind the scenes:
- Borrow stock: We use your core portfolio as collateral and borrow the shares from a brokerage lending pool.
- Sell stock: Those borrowed shares are sold immediately at market price.
- Marked to market: We check the position values daily to ensure there is adequate collateral.
- Buy to cover: When it’s time to close the position, we buy back the same number of shares and return them
- Profit or loss: The difference between sale price and repurchase price, minus fees, is your gain or loss.
We hold cash proceeds from short sales at our clearing firm, Apex Clearing. These funds may earn interest, which can help offset borrowing costs. If shorted stocks pay dividends, you’re responsible for equivalent payments back to the lender.
How we choose short positions
We use an optimizer to determine the best short positions based on your selected factors and portfolio goals. For example, our optimizer prioritizes shorting “easy to borrow” stocks to minimize borrowing costs and reduce liquidity risks. Easy to borrow stocks are readily available for borrowing. They’re highly liquid with many outstanding shares, making them easily accessible with little to no borrowing costs. Hard to borrow stocks are more challenging due to limited availability or high volatility. They also come with higher borrowing costs so we generally try to avoid them.
We also limit each individual short to less than 1% of your total portfolio and maintain diversified short positions. This helps keep tracking error minimal relative to your benchmark and reduces transaction costs and unnecessary turnover.
Risk management
Borrowing against your portfolio comes with risks. Here’s how we mitigate them at Frec:
- We place borrowing limits to prevent over-leveraging
- Caps on positions ensure no single short makes up a large share of your portfolio
- We monitor borrowing costs and stock availability daily
- We conduct daily margin reviews on all long short accounts
Because we are leveraging your core portfolio, a margin call is possible but also highly unlikely. Our 140/40 strategies have an excess margin minimum of 45% built in to keep these risks low. If a margin call were to happen, we would handle it for you by rebalancing within the account.
Pricing
Long short direct indexing has been historically limited to institutions or ultra-high-net worth individuals due to high minimums and advisor fees.
At Frec, we’re changing this.
Our long short strategy does not require a human advisor and thus has no additional advisor fees. We have a 0.50% AUM fee, and we pass along financing costs from our clearing firm to the customer (approximately 0.50% fees on the 40% long and short extensions).
While the cost is higher than classic direct indexing, you may also get higher returns. When you factor everything in, you could earn an additional 3% annual post tax returns which is more than enough to offset the fees.
Picking a long short direct index strategy
Here are three scenarios that could help you decide if long short is right for you:
Investor A: You have major capital gains accumulated over many years, such as from concentrated stock positions or ongoing K-1 distributions. You’re also interested in maintaining or increasing exposure to a specific investment factor within your portfolio as you diversify.
→ Consider long short
Investor B: You have one-off or near-term capital gains, such as from a single liquidity event like selling a company. You also want to use this opportunity to both manage taxes and align your portfolio with a particular investment factor tilt.
→ Consider starting with long short and then transitioning back to classic direct indexing
Investor C: You have potential gains in the future such as selling a home in 10 years or making withdrawals from a taxable account during retirement.
→ Consider classic direct indexing
If you’re not sure about which strategy is right for you, you can schedule a call with our team of licensed professionals and we’ll give you a complimentary portfolio analysis.
Transitioning between long short and classic direct indexing
One advantage of Frec’s platform is flexibility between strategies. Here’s how you can switch between strategies:
From long only to long short: You can transition almost instantly, depending on your long-only strategy.
From long short to long only: You can do this without any tax impact by using a small amount of the losses harvested while in long short. Historically, after one year of a value-tilted long short strategy, you can harvest on average 21.84% in losses. To transition out at the end of year one you may need to use about 3.8% of those losses to offset gains from transitioning back to a classic direct index.
Moving between long short strategies: Coming soon!
Other limitations and considerations
While long short direct indexing offers significant benefits, there are some important considerations to be aware of. One is that to prevent shorting against the box, if you or your spouse hold long positions in the Russell 1000 outside of Frec, then you either need to consolidate those into your long short index, sell them, or add them to your “do not short list” when setting up an account or afterward by visiting your Account Settings.
For the same reason and because of wash sales, you can’t have long-only direct indices with overlapping exposure. The following indices are allowed while holding a long short direct index:
- S&P Developed Markets ADR
- S&P Emerging ADR
- Russell 2000
- MVIS® US Listed Semiconductor 25
- S&P 500® Information Technology
Furthermore, you can have a portfolio line of credit while also investing in a long short direct index, as long as you have long only direct indices and/or self-managed positions that you can borrow against. You cannot, however, borrow against your long short direct index for a portfolio line of credit since it’s already being used to fund the long and short extensions.
Getting started
Long short direct indexing was once reserved for hedge funds and clients paying 1% to an advisor just for access and at high minimums. At Frec, we’re making it available to more investors by lowering the minimum investment to $100,000, no human advisor needed.
If you’re new to Frec, you can create an account here in just a few minutes. For existing customers, we’re currently working on making the transition available. If you want to get started sooner, you can email our team at help@frec.com and we’ll get you set up.
For more details, you can check out our live demo account, read our white paper, or schedule a call with our team.
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.
