Long-Short Direct Indexing: The Future of Tax-Efficient Investing
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Table of Contents
What Is Long Short Direct Indexing?
How Does Long Short Direct Indexing Work?
Key Benefits of Long Short Direct Indexing
Tax Nuances You Need to Understand
Risks and Considerations
Is Long Short Direct Indexing Right for You?
Long Short Direct Indexing vs Alternatives
Frequently Asked Questions
Accessing Long Angle's Long Short Indexing Partnership
Direct indexing — which allows investors to own components of the stocks of an index rather than a fund or ETF — has become popular in recent years as a way to track market returns while also harvesting significant tax losses. Long-Short Direct Indexing (LSDI) represents the next step in this strategy.
In a “140/40” LSDI, investors buy 140% of the index in individual stocks, while selling short an offsetting 40%. The resulting portfolio still delivers the overall market return, but with dramatically more opportunity to harvest taxable losses, and to do so for a longer period of time and in a wider variety of market conditions.
In this guide, we’ll cover:
What long short direct indexing is and how it works
Benefits and risks investors need to understand
Key tax nuances (like wash sale rules and deductibility limits)
Who this strategy is best suited for — and who should avoid it
How it compares to ETFs, traditional direct indexing, and tax-managed funds
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What Is Long Short Direct Indexing?
At its core, long short direct indexing is a portfolio construction method that mirrors a benchmark index (such as the Russell 1000 or S&P 500) while incorporating long and short positions. Learn more about how long/short indexing benchmarks work in practice.
Long positions: Owning stocks expected to rise in value.
Short positions: Borrowing and selling stocks expected to decline in value, with the intention of buying them back at a lower price.
A typical structure is 140/40:
100% invested in long index positions
40% added long exposure (via leverage)
40% short positions within the same universe
This keeps net market exposure near 100% while multiplying opportunities for tax-loss harvesting and fine-tuned factor tilts (like value, growth, or quality).
How Does Long Short Direct Indexing Work?
Custom Index Creation
You start with a baseline index (Russell 1000, S&P 500, etc.) and adjust it for your needs (ESG, sector exclusions, factor preferences). This aligns well with advanced factor-based investing principles described in Frec’s white paper.
Short Overlay
The manager shorts ~40% of selected stocks (often “easy-to-borrow” names). This adds diversification of “loss harvesting opportunities” and creates more flexibility to express views on overvalued companies.
Leverage & Positioning
A 140% gross long position balanced by a 40% short position nets out to 100% market exposure. Leverage allows the portfolio to stay aligned with the market while creating room for more customization and tax efficiency.
Tax-Loss Harvesting
In rising markets, short positions generate losses that can be harvested. In falling markets, long positions generate losses that may be harvested. This dual opportunity creates a steadier stream of “tax alpha.” For additional background on tax harvesting strategies, see a complete guide on tax-loss harvesting.
Key Benefits of Long Short Direct Indexing
Tax Alpha (After-Tax Return Boost)
Traditional direct indexing might harvest ~40% of initial investment losses over 10 years. LSDI can more than double that, reaching ~100%, as shown in Frec’s research.
Consistent Harvesting Across Market Cycles
Unlike long-only direct indexing where opportunities shrink in prolonged bull markets, LSDI tends to maintain higher harvesting capacity (~8% annually even after 10 years).
Factor Tilts & Customization
Allows exposure to factors like small-cap value or quality, and the ability to exclude sectors or companies that don’t align with investor preferences.
Portfolio Hedging & Downside Protection
Short positions can act as a hedge during downturns, making the portfolio less volatile than a pure long-only strategy.
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Tax Nuances You Need to Understand
Tax efficiency is the main selling point, but there are important limitations and rules to know.
Wash Sale Rules
Losses from selling a security can be disallowed if you repurchase substantially identical securities within 30 days. Managers often use ETFs as placeholders or swap in correlated names to maintain exposure, a technique discussed in our tax-loss harvesting strategies article.
Character of Losses
Many harvested losses will be short-term, which are valuable because they can offset short-term gains (taxed at higher rates). Investors must understand the mix between long- and short-term harvesting.
Deduction Limits
Investors can deduct up to $3,000 of net capital losses against ordinary income per year. Larger excess losses carry forward indefinitely, but you need ongoing gains to absorb them. For detailed IRS guidance, see the IRS Capital Loss FAQ.
Offsetting Gains
LSDI is especially powerful for investors with consistent capital gains (from stock sales, real estate, or business liquidity events). Without gains, losses accumulate but may not provide near-term benefit.
Risks and Considerations
Leverage Risk: Borrowing to achieve 140% long exposure can magnify both gains and losses.
Short Sale Risk: Potential for unlimited losses if shorted stocks rise dramatically. Risk controls like 1% position caps help but don’t eliminate danger.
Financing Costs: Interest on borrowed funds (currently ~0.5%–1%) could climb significantly if rates rise, cutting into net alpha.
Complexity & Tracking Error: Compared to ETFs, this is a more active and complex strategy. Factor tilts and trading decisions may lead to tracking error vs. the index.
Account Requirements: Investors need a margin-enabled account and usually significant assets ($250,000+ is common for LSDI providers) to make the costs worthwhile.
Is Long Short Direct Indexing Right for You?
Best For:
High-net-worth and mass-affluent investors
Investors regularly realizing gains (e.g., fund distributions, portfolio rebalancing, business/liquidity events)
Long-term investors comfortable with complexity and customization
Not Ideal For:
Investors in low tax brackets or those without consistent capital gains
Short-term investors who may not stay the course long enough
Risk-averse investors unwilling to handle leverage or shorting strategies
Long Short Direct Indexing vs Alternatives
| Strategy | Tax-Loss Harvesting | Costs | Complexity | Customization | Market Exposure |
|---|---|---|---|---|---|
| ETFs | Low (occasional) |
Low | Low | Minimal | Broad-based |
| Direct Indexing | Moderate (declines over time) |
Low/Moderate | Medium | High | Tight tracking |
| Long Short Direct Indexing | High & sustained |
Higher (0.5–1% fees + financing) | High | Very High | 100% net with leverage |
| Tax-Managed Funds | Moderate | Moderate | Low/Medium | Low | Fund dependent |
Frequently Asked Questions
What is a long-short index?
A long-short index is a benchmark that combines long positions in favorable securities with short positions in unfavorable ones to capture both upside and downside opportunities. See S&P DJI Alternative Beta indexes.
What is long-short direct indexing?
It’s a tax-efficient investment strategy that combines direct indexing with long/short overlays, creating both more tax-loss harvesting opportunities and personalized factor tilts.
What are the 4 types of portfolio management strategies?
Active, Passive, Discretionary, and Non-Discretionary — LSDI is an advanced hybrid blending active and passive features.
What is the difference between long and short index investing?
Long investing means owning securities expected to rise. Short investing means betting against securities expected to fall by selling borrowed shares. LSDI blends both.
Accessing Long Angle's Long Short Direct Indexing Partnership
Want to know if Long Short Direct Indexing (LSDI) is the right tax-efficient strategy for your portfolio?
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