{{item.videoDuration}}
{{item.title}}
{{item.text}}
{{item.videoDuration}}
{{item.text}}
Recently, there have been a lot of discussions focused on 'tax alpha' and tax-aware funds. But tax-aware investing itself is not new. Investment managers have long considered the tax consequences of portfolio construction, trading frequency, holding periods, and the character of investment income.
What has changed is the level of investor expectations and, in response, the sophistication of the products being offered. Tax-efficient execution is increasingly viewed as the baseline, and managers are evaluated based not only on gross or pretax performance, but also on what investors retain after tax as they seek differentiating ways to generate alpha.
In response, a new class of products is being intentionally designed, marketed, and evaluated based on net, after-tax results. The discussion below highlights several tax-aware strategies but is not intended to serve as a comprehensive list or guide.
Treasury and IRS officials recently spoke about tax-aware funds during a public panel discussion. They emphasized that, while they are not challenging tax-aware investing or routine tax planning generally, they are focused on transactions that use technical rules in coordinated or selective ways to produce results that appear inconsistent with their economic substance. The government is gathering information to determine where to draw the line and is considering targeted guidance and enforcement under both existing law and future rules, particularly for strategies that generate tax-free diversification, avoid income recognition, or selectively convert the character of gains and losses.
Defining tax alpha
Traditional investment alpha measures outperformance relative to market risk. Tax alpha seeks to measure the tax value generated by an investment strategy. That value may come from lower tax rates, the deferral of tax, or the creation of tax attributes that are particularly useful to an investor. The methods used to calculate tax alpha, however, can vary.
The impact of timing and present value
These approaches can be instructive, but they still fall short because paying tax several years from now can be less costly than paying it today because the investor retains capital that can continue to compound. Even a multi-year calculation will not fully capture an individual investor’s outcome. A fund may assume, for example, that short-term capital losses will offset an investor’s short-term capital gains. An investor with only long-term gains may receive a smaller character benefit, while an investor without sufficient gains may have to carry the losses forward, delaying their value.
Tax alpha should, therefore, be viewed as a framework for evaluating potential tax value, not as a universal return measure. The more important question is not simply how much tax alpha a strategy reports, but how much of that value a particular investor can realize, over what period, and under what assumptions.
After-tax product innovation
We are seeing a new class of products in which the after-tax result is a central part of the value proposition. These products generally fall into two categories:
- Tax attribute-matching and custom outcome funds. These funds are designed around a particular investor tax profile, such as generating income that may be absorbed by existing passive losses.
- Strategy-based tax-aware products. These funds use portfolio construction, trading decisions, and financial instruments, including leveraged long/short strategies and swaps, to influence the timing and character of income, gains, losses, and deductions.
Tax attribute-matching and custom outcome funds
Other products are designed around a particular investor’s tax profile. A vehicle might, for example, seek to generate income that can absorb existing passive losses or produce a particular type of gain, loss, or deduction that complements attributes held elsewhere in the investor’s portfolio. The value of these customized outcomes depends heavily on investor-specific limitations, character, basis, and timing.
Strategy-based tax-aware products
Leveraged long/short
A leveraged long/short strategy combines long positions, short positions, and borrowing to create greater gross market exposure than a long-only fund. For example, a 150/50 fund may hold $150 of long positions and $50 of short positions, while maintaining $100 of net market exposure. The primary goal is economic performance, not tax efficiency, which is a by-product.
A tax-aware fund uses the same basic structure but incorporates tax considerations into its trading decisions. The manager may recognize short-term losses sooner, defer selling appreciated positions, and hold gains long enough to qualify for long-term capital gain treatment, all while maintaining the same overall net exposure as the long-only strategy.
Notional principal contracts (Swaps)
Capital losses generated by a 150/50 fund are generally most useful when an investor has capital gains elsewhere to offset and has limited value against other types of income. Some tax-aware funds therefore use notional principal contracts, commonly called swaps, in an effort to generate ordinary deductions while recognizing gains as long-term capital gains.
Under a typical equity swap, the fund enters into a contract with a bank that gives it the economic return of a particular stock without requiring the fund to purchase the stock directly. The fund pays the bank a periodic financing charge. If the stock increases in value, the bank pays the increase to the fund. If the stock declines, the fund pays the decline to the bank. The fund uses this structure because the financing charges and certain payments arising from a decline may be treated as ordinary deductions, which could be more useful to investors than capital losses.
Some tax-aware funds may rely on a “wait-and-see” approach for certain payments, under which the fund delays recognizing certain payments until the amount becomes fixed. If the contract produces a loss, financing payments and other amounts paid by the fund may be treated as ordinary deductions. If the contract is profitable, the fund may terminate it in an effort to recognize capital gain, which may be long-term capital gain if terminated after one year. The intended result is to generate deductions potentially usable against higher-taxed ordinary income while recognizing gains at lower long-term capital gain rates.
Rules that can limit the tax benefit
Excess business loss limitation: A key limitation is that individual investors may not be able to use all of the fund’s ordinary deductions immediately. The excess business loss rules generally limit business deductions to business income plus an annual threshold, with any disallowed amount carried forward as a net operating loss. As a result, the timing and value of the deductions will depend on each investor’s other income and tax attributes, reinforcing that tax alpha cannot be measured solely at the fund level.
Other strategy-based products
Intraday foreign currency (FX) trading: Intraday FX traders can utilize specific elections to obtain better tax results. Because these elections are made on a contract-by-contract basis at the end of the day, a trader can identify "winners" and "losers" before making the election, seeking capital treatment for gains while retaining ordinary treatment for losses.
Exchange Funds: For those with concentrated appreciated positions, exchange funds allow for diversification without immediate gain recognition. To receive a diversified basket of securities tax-free, investors must maintain their interest for at least seven years. Modern managers are now pairing these with long/short strategies to seek diversification benefits more quickly and synthetically.
Technical constraints and anti-abuse regimes
The products described above can require significant operational infrastructure, including near-real-time compliance systems, tax-allocation platforms, daily valuation feeds, and robust documentation. The requirements vary by product, but successful execution depends on accurately identifying, tracking, and allocating the intended tax attributes.
The specific rules are also overlaid by broader anti-abuse principles, including the economic substance doctrine. A strategy must have a meaningful non-tax purpose and produce a real change in the investor's economic position. If a transaction is entered into solely to obtain tax benefits without a legitimate commercial rationale, the IRS could disregard it.
The investor’s tax position matters
Across all categories, a fund's reported tax alpha may not be the tax alpha experienced by a particular investor. Before relying on a projected benefit, an investor should consider several questions.
- Do you have sufficient basis and amounts at risk to deduct the losses allocated by the fund?
- How do the tax adjustment rules apply across your portfolio?
- Will the character generated by the fund be useful to you?
- Are you prepared for the eventual recognition of deferred gains?
The relevant question is therefore not simply, “What is the fund’s tax alpha?” It is, “What tax value is this strategy likely to produce given my income, outside investments, basis, holding period and exposure?”
The future of value creation
Tax-focused investment vehicles are becoming more accessible, while technology is making complex tax management easier to execute at scale. As a result, tax considerations are increasingly being built into product design rather than addressed only after investment decisions are made.
The products discussed above represent only a portion of the growing after-tax product landscape, and this article does not address every potential trap or technical issue. Managers and investors should evaluate the expected benefits in light of the product's structure, the applicable tax rules, and the investor's individual circumstances.
Explore the full 2026 Private Capital Outlook
Four predictions on shaping the future of fundraising, liquidity, and tax strategy
{{filterContent.facetedTitle}}
{{contentList.loadingText}}
{{contentList.loadingText}}
Follow us
