Hedge fund tax strategies fuel surge in US margin lending
Growing demand for tax-efficient long-short investment strategies offered by hedge fund managers including AQR and Quantinno has contributed to a sharp increase in US margin lending, with Charles Schwab reporting borrowing balances of $188bn in the third quarter, according to a report by the Wall Street Journal. Schwab's margin loan balances nearly doubled year on year, including approximately…
Hedge fund managers such as AQR and Quantinno have witnessed increased demand for tax-efficient investment strategies, leading to a significant rise in US margin lending. Charles Schwab reported a borrowing balance of $188 billion in the third quarter, a nearly doubling from the previous year.
These tax-aware long-short strategies utilize leverage and short selling to generate tax losses while aiming to match or surpass equity indices. Assets managed through these strategies have surged to nearly $190 billion, having grown from over $1 billion five years prior, according to estimates from Tax Alpha Insider's Brent Sullivan.
The strategies typically involve borrowing against an investment portfolio to establish additional long and short equity positions, enabling investors to realize losses that can offset taxable capital gains while maintaining broader market exposure. Schwab's CEO, Rick Wurster, mentioned that adoption of these strategies has expanded exceptionally quickly this year, driven by demand from high-net-worth investors looking to reduce their tax liabilities.
However, the rapid growth in tax-aware strategies has raised concerns over leverage and operational risks associated with the approach, prompting major custodians to limit new investments. Fidelity Investments suspended the opening of new accounts for the strategies in February, resulting in a surge of assets at Charles Schwab. In response, Schwab introduced restrictions, raising the minimum investment for certain new accounts from $1 million to $10 million and temporarily halting new client enrollments and additional funding in portfolio margin accounts.
The growth in tax-aware strategies has coincided with an overall increase in borrowing across Wall Street. Firms such as Morgan Stanley, Bank of America, and Goldman Sachs reported double-digit annual growth in their margin lending businesses within the 12 months leading up to September. Total US margin debt reached $1.45 trillion in August, nearing the record $1.5 trillion recorded earlier in the summer.
The expansion in tax-aware strategies has been accompanied by a broader rise in borrowing on Wall Street, as rising equity markets have necessitated additional collateral for short sellers, potentially increasing their borrowing requirements. Leveraged funds have seen assets exceed $180 billion during the second quarter.
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