Inside Charles Schwab Corp.’s headquarters in Westlake, Texas, the warning signs were becoming hard to ignore.
For months, the brokerage had piled into one of the hottest trades on Wall Street: “tax-aware long-short” accounts, which are helping legions of wealthy investors whittle down their tax bills. Millionaires love it so much they’ve poured roughly $150 billion into such strategies in just three years, by some estimates, and the tally is growing by the day.
At Schwab, revenue from the business climbed to roughly $70 million by the second quarter, but executives were becoming concerned that it was growing so fast the situation could get out of hand quickly. If things went awry, the thinking went, Schwab would be on the hook—or, worse, they’d find themselves in the middle of a shock to the market.
So instead of popping the bubbly, the 55-year-old company is pulling back on what’s becoming the next great American tax dodge.
“There’s no other reason to do it than avoid paying taxes,” said Sheila Bair, former chair of the U.S. Federal Deposit Insurance Corp. who helped clean up the banking industry in the aftermath of the 2008 financial crisis. “There’s risk for the firms offering this.”
In April, and then again in June, Schwab tightened the screws on who can set up tax-aware long-short accounts on its platform. It curbed how much of a financial adviser’s total assets can be invested in such accounts, increased the minimum amount needed to get started, instituted borrowing limits, imposed margin requirements and said it will issue margin calls and contact advisers if any of their accounts exceed the new thresholds. All of those new requirements served to push at least some business away.
Schwab had become one of the two major custodians facilitating tens of thousands of these complex accounts in mere months. By the end of June, the firm said, the strategy was already contributing about 1% of the firm’s overall revenue, a small yet stunning sum considering Schwab broke into the business only last year.
It wasn’t alone in pulling back, with rival Fidelity Investments taking more drastic measures. The largest U.S. brokerage, with almost $20 trillion under administration, Fidelity had set up the first tax-aware long-short account for a client years ago and for a time was the only firm to broker such accounts. A few months before Schwab reined the business in, Fidelity indefinitely shut its doors to new clients and hiked fees for some existing ones. The Boston-based firm hasn’t given a detailed explanation publicly for the change.
That two of America’s largest financial institutions decided to turn down tens of billions of fee-paying dollars marks a stunning reversal at a time when Wall Street firms are piling into the strategy.
One of the things that most worried Schwab was that many wealthy people were so enticed by the potential of eliminating taxes they didn’t quite grasp what they were getting themselves into, according to people with knowledge of the company’s thinking. Even some financial advisers pitching them the strategy didn’t understand the complexities.
“These sophisticated strategies can involve thousands of positions and significant client reporting intricacies,” said Jalina Kerr, a managing director at Schwab’s Advisor Services unit, which deals directly with such products. Clients end up receiving several hundred pages of tax documents coming from these trades alone, she said, surprised by the volume of paperwork.
Schwab’s finance chief said on an earnings conference call last month that the strategy has “grown very quickly” and now represents “roughly 1%” of the firm’s revenue, which totaled $7.07 billion in the second quarter. Chief Executive Officer Rick Wurster told Bloomberg News that Schwab wants to support these strategies and is going to great lengths to make sure financial advisers understand just how complex and risky such accounts can be. It’s the reason why the firm updated disclosures on the products, he said.
The tax-aware long-short strategy sits on the cutting edge of the $1 trillion “tax alpha” universe that, through hosts of products, helps rich people postpone or eliminate capital-gains taxes. The strategy is engineered to create losses alongside long-term gains by betting both on and against companies. It’s intended to save the wealthy from paying taxes on big capital events—whether it’s piling up a fortune from private equity, selling a company or making a killing in the stock market—money that would otherwise go to the government.
Fidelity and Schwab provide the financing and stock loans that such strategies need to operate. To work, these accounts require relentless daily transactions, heavy borrowing that can trigger margin calls for investors, a large number of stocks to bet against and sometimes complex derivative contracts—all complicated to do, and financially dangerous for investors if it goes wrong. The strategy is so byzantine that Schwab had to hire dozens of new employees to deal with its intricacies.
The fear for some in the industry goes like this: As more money piles into the strategies, more of the same stocks are shorted, which can overload such trades. A sudden loss can force everyone to unwind positions at once, causing a market disruption. Clients can also be asked to put up more cash to cover losses but, if they don’t have the funds, the brokerage would have to close out their positions. If that’s still not enough, the firm would have to cover the shortfall itself.
One wealth manager who advises sophisticated family offices said that he tells clients to have hundreds of thousands of dollars available in case they need to post collateral—or not use the strategy at all. He asked not to be identified discussing private conversations with clients.
Fidelity declined to make executives available for comment or answer specific questions about its decisions around tax-aware long-short strategies. In an emailed statement, a spokesperson said Fidelity was “an early mover in making these strategies available” on its platform for third-party wealth-management firms before later restricting access.
“In exceptional situations like this, it is prudent to take time to evaluate the industry landscape and drivers of sudden changes,” the spokesperson said. “Fidelity chose to restrict access to new clients due to the unprecedented growth of these strategies on our platform and anything asserting otherwise is inaccurate and false.”
First Account
At first, Fidelity had said no.
In 2021, in the middle of the coronavirus pandemic, the founder of a little-known firm with only a couple hundred million dollars of assets approached Fidelity and asked its brokerage to set up a long-short account for one of his clients.
The Korean-born Hoon Kim, who holds a doctorate from Carnegie Mellon University, had previously worked at a far-better-known hedge fund, AQR Capital Management, which pioneered the idea of placing long and short bets to shrink investors’ tax bills. Kim was part of the team that first came up with the concept for the innovative strategy and, now at his own firm, he was trying to find a way to get the idea off the ground and bring it to the wider wealth market, according to a person with knowledge of his pitch.
Fidelity had never heard of Kim or his firm, Quantinno Capital Management, and passed, the person said. But it reconsidered when one of Kim’s clients, who also happened to be an existing Fidelity client, asked the firm to do it. Quantinno and Fidelity declined to comment.
The first tax-aware long-short separately managed account for the wider wealth market went live on Fidelity’s platform in October 2021. It was a couple of years later that Fidelity opened the strategy up to other asset managers. The money started flowing in.
No one at the time could imagine a rise so dramatic it would prompt the country’s biggest brokerage to tap the brakes. Kim’s Quantinno, which focuses exclusively on such tax-loss strategies, now has about $60 billion of assets, up from almost nothing five years ago. AQR has leapfrogged rivals to become the world’s largest hedge fund, surpassing $140 billion of such assets at the end of March. About $70 billion of that is in tax-loss strategies, up from about $3 billion in 2023. To put that in perspective, it took decades for some of the most prominent hedge funds to reach such amounts.
The explosive growth of tax-aware strategies has spurred even President Donald Trump’s administration—which generally favors lighter regulation and lower taxes—to take a closer look at the products.
At an industry gathering in New York last month, Treasury Department officials warned that some strategies in the wider universe of techniques designed to help people slash their tax bills may be crossing lines “that should not be crossed.”
The Pullback
When Fidelity pulled back, many wealth managers immediately ran to Schwab. But the minute Schwab curbed access as well, the phones started ringing at less-traditional firms. One of them is Apex Fintech Solutions, a Dallas-based software company that provides back-end infrastructure for digital investing, trading and wealth management.
Executives at the firm woke up to scores of calls from advisers asking if they could take on custody of tax-aware long-short accounts, said Connor Coughlin, Apex’s chief customer officer, who calls himself a “Financial Plumber” on his LinkedIn page. They “showed up and said, ‘Hey we’re interested in this, can we do this?’” The answer was yes—he could arrange it.
Goldman Sachs Group Inc. and Bank of New York Mellon Corp.’s BNY Pershing brokerage platform have started offering custody services for such tax-aware accounts as well, rapidly filling the gap left by Fidelity and Schwab.
“Our longstanding expertise as prime brokers, where we’ve delivered the most sophisticated strategies to institutional investors for decades, makes us well-positioned to bring that same institutional-caliber service to registered investment advisers and the wealth segment,” a Goldman Sachs spokesperson said in an emailed statement.
A representative for BNY Pershing declined to comment.
A Colorado wealth manager who specializes in tax planning said the strategies are not only popular with wealthy clients, they also justify the fees paid to financial advisers, with the tax savings sometimes reaching as high as 10 times their expenses. On the West Coast, Gabriel Shahin, whose Falcon Wealth Planning oversees about $4 billion, said some advice firms with less than $10 million in assets are now offering such strategies to almost their entire client bases.
“These are small shops,” he said, “and it’s 100% of their strategy.”
Even with the pullback, the trade is hardly disappearing at Schwab. The brokerage recently recruited for a new role: someone to lead its long-short separately managed account strategy and program office, with a salary as high as $269,900.
One Boston-based adviser to high-net-worth individuals—who asked not to be identified because of concerns over client confidentiality—put it this way: On hearing the Schwab news, some of his biggest clients feared the firm would put in place increasingly draconian restrictions. Their response? Add even more money to their tax-aware accounts at Schwab while that’s still possible.
This article was provided by Bloomberg News.