Schwab's long-short plans raise questions about competition

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• Key insight: Schwab's introduction of its own version of a popular long-short strategy used to minimize tax bills presents possible competition to third-party providers of similar offerings. 
• Supporting data: Schwab's margin loan balances surged to $188 billion in the third quarter, with nearly a third — roughly $61 billion — driven directly by demand for long-short strategies.
• Expert quote: "If the minimum for Schwab's product is $500,000 or $1 million, it starts to look a little competitive, especially versus the third-party managed solutions which a lot of advisors and investors really like." — Brent Sullivan, editor of Tax Alpha Insider

With investors dreading their tax bills after years of market appreciation, Charles Schwab is devising its own version of an investing strategy designed to tamp down payments to the IRS.

But, as with many recent initiatives by Schwab, some question whether its new long-short product presents a new form of competition to outside asset managers and other firms.

In an earnings call last week, CEO Rick Wurster said Schwab plans to release its own version of the tax-aware long-short investing strategies that have grown increasingly popular among investors seeking to reduce their capital gains tax bills. Long-short strategies use borrowed money to magnify investment losses that investors can claim when trying to lower their tax liability.

In response to a question from UBS analyst Mike Brown about the possibility of a Schwab long-short product, Wurster said, "I do expect us to have an offering." One goal of the strategy, Wurster said, will be to "deliver monetization" — or make it easier for clients to turn stocks and other assets into cash.

"But more importantly, it's a way we can deliver sustainable long-short strategies to our clients in a way that is operationally and financially manageable over the longer term," he said. Wurster added that more details about the new strategy and its official launch date will be announced in future earnings calls.

Schwab raises its minimum for outside long-short strategies

Schwab's plans to introduce its own tax-aware long-short strategy comes after the firm said last month that it was raising the asset minimum for clients who want to access long-short offerings from third-party asset managers and other firms. Schwab clients now need at least $10 million to participate, up from $1 million previously.

Brent Sullivan, an independent tax analyst and the editor of Tax Alpha Insider, said Schwab's higher minimum, alongside its plans for a proprietary long-short product, raises big questions concerning competition. 

Will Schwab apply the same asset floor to its own offering? Or will it effectively keep the smaller accounts for itself while sending only large ones to third-party providers? And will Schwab's in-house advisors, which it calls financial consultants, have incentives to favor the firm's in-house offering over rival products?

"If the minimum for Schwab's product is $500,000 or $1 million, it starts to look a little competitive, especially versus the third-party managed solutions, which a lot of advisors and investors really like," Sullivan said.

A Schwab spokesperson declined to comment beyond what executives said in the recent earnings call. On the call, executives did not discuss possible asset criteria for the new offering but did acknowledge the popularity of long-short strategies among clients.

Wurster said Schwab had to raise its asset minimum and take other steps to "throttle" money flowing into the strategy "for a period of time to make sure that we can support this from an operational standpoint, from a capacity standpoint, and we've done that.

"And as we look forward, we're looking at multiple ways of supporting our clients' needs around long-short because we know there's demand for it," he said.

Inflows to long-short strategies booming

The popularity of long-short strategies was clear in Schwab's latest earnings report. The firm's balance for margin loans nearly doubled year over year to $188 billion in the third quarter. Of that, roughly $61 billion was related to long-short strategies.

Sullivan's Tax Alpha Insider has found that the popularity of long-short offerings has ballooned in recent years. Asset managers now have roughly $190 billion in the strategies, up from just over $1 billion five years ago.

With the strategy involving so much borrowed money, long-short offerings are commonly perceived as inherently riskier than other investing methods. Schwab isn't the only firm to adopt restrictions aimed at preventing retail investors from getting in over their heads.

Fidelity Investments, for instance, announced in February that it was indefinitely barring clients from opening new long-short accounts. Brad Wales, the founder of the consulting firm Transition to RIA, said Schwab's plans to offer its own long-short product may be guided as much by a desire to control liabilities as to boost revenues.

"However, as these strategies rapidly gain popularity, adding an additional revenue stream is quite appealing," he said.

Risks and benefits of long-short strategies

Long-short strategies can be particularly useful during prolonged bull markets, like the one of the past four years, when other ways of mitigating tax bills lose effectiveness. XY Planning Network founder Michael Kitces explained in a blog post on the strategy that standard tax-loss harvesting, in which losses on stock sales are used to offset capital gains, tends to lose its effectiveness over long stretches.

That's because as share values move steadily upward over time, they become increasingly unlikely to fall below the price at which they were originally bought. Long-short strategies can overcome this by amplifying losses either on long investments that fail in bear markets or short investments that fail in bull markets.

But the risks of a tax-aware long-short strategy, or TALS, can leave investors worse off than if they had left their investments in a standard portfolio, Kitces cautioned.

"Or put differently, increasing leverage in a TALS increases the potential tax benefits it can generate, but also increases the risk that it may underperform enough that the investor would have been better off simply selling their concentrated security and paying tax on it!" Kitces wrote.

But with so many investors eager to lower their tax bills, firms like Schwab are likely to press on with finding new ways to offer long-short strategies.

"Saving money on taxes is something our clients love to do," Wurster said in the earnings call. "That demand is likely to continue."   

Introductory bullet points created by AI with editorial review.