Tax-Efficient Strategies Fuel Surge In US Margin Lending

Tax-aware long-short strategies helped drive a sharp increase in US margin lending, lifting Charles Schwab’s borrowing balances to $188bn in the third quarter, nearly double the level a year earlier. About $61bn was tied to the strategies, which use borrowing and short selling to generate tax losses while keeping investors exposed to equity markets.

The strategies are designed for investors seeking to reduce taxable capital gains. Managers borrow against an investment portfolio to establish additional long and short positions. Losses from some positions can then offset gains from other investments.

Assets managed through tax-aware long-short strategies have increased to nearly $190bn from just over $1bn five years ago, according to estimates by Brent Sullivan of Tax Alpha Insider. Demand has grown among wealthy investors seeking to lower their tax bills while matching or outperforming equity indexes.

Charles Schwab Chief Executive Rick Wurster described adoption of the strategies as having grown “exceptionally quickly” this year. Schwab has raised the minimum investment for some new accounts from $1m to $10m. It has also stopped accepting new clients and additional funding in portfolio margin accounts.

Fidelity Investments suspended new account openings for the strategies in February. The decision redirected assets to Schwab and increased demands on its operations.

Wurster said the limits were intended to help Schwab manage the strategies and support their growth. The brokerage is developing its own tax-aware long-short investment product, which could compete with hedge fund managers including AQR and Quantinno.

The increase in tax-aware strategies has coincided with broader growth in margin lending across Wall Street. Morgan Stanley, Bank of America and Goldman Sachs each reported double-digit annual growth in their margin-lending businesses in the 12 months to September.

Total US margin debt reached $1.45tn in August, according to data from the Financial Industry Regulatory Authority. That was close to the record of $1.5tn set earlier in the summer. Rising share prices can increase borrowing needs because short sellers must provide more collateral when the value of securities they have sold rises.

Assets in leveraged funds exceeded $180bn in the second quarter. These funds use borrowed money to increase market exposure. The expansion of tax-aware strategies has increased the use of leverage and the number of long and short positions that firms must manage.