The Paper Trail: Wag the Dog

Greetings from sweet-home Chicago!

Last week I was in Seattle for the inaugural Basis Northwest, hosted by Brent Sullivan of Tax Alpha Insider. The conference brought together advisors, allocators, and tax specialists to discuss what is quickly becoming one of the most dynamic areas of portfolio construction: tax-aware investing.

always nice when the conference supplies something to bring home to the kiddos!

What struck me was how much the conversation has evolved. Tax-loss harvesting and asset location were certainly discussed, but so were tax-aware long/short strategies, box spread financing, variable prepaid forwards, 351 exchanges into ETFs, private placement life insurance, tax-aware real estate, and increasingly personalized approaches to tax management. There was also significant discussion around the growing overlap between investment management, income planning, and estate planning.

The common thread was that taxes are no longer viewed as an afterthought. They are increasingly being incorporated directly into the asset allocation process.

One of the more interesting papers in this month's roundup comes from Burney Advisor Services and carries the title "Don't Let the Tail Wag the Dog." The paper focuses on tax-aware long/short strategies, but its broader lesson applies well beyond that niche. Tax efficiency can improve outcomes, but it cannot create them. A strategy still needs sound economics, sensible portfolio construction, and a source of expected return.

As the tax toolkit grows larger and more sophisticated, maintaining that perspective becomes increasingly important. Taxes deserve a seat at the table, but they shouldn't be sitting at the head of it. The ultimate objective remains the same: building and preserving after-tax wealth.

Now, onto the May edition of The Paper Trail. Topics featured in this month's research roundup include:

• Global diversification in a deglobalizing world
• Private equity's distribution drought
• The economic life of AI hardware  
• Redemption activity in semi-liquid private credit funds
• AI picks-and-shovels in emerging markets
• Looking for quality in GP-led secondaries
• Geopolitical risk and managed futures
• Alpha and tax-aware long-short strategies
• Moats and value traps in software stocks
• Inflation and stock-bond correlation
• TPA and diversifying beyond the pie chart
• Luck and skill in direct lending
• The road to a trillion dollar secondary market
• Real assets and the physical economy
• Investing in the rearview mirror

If deglobalization lowers correlations, should investors become more global, not less?

"Perhaps counterintuitively, as the world deglobalizes, risk-minimizing investors should respond by making their portfolios as global as possible. A world of less-correlated equity markets is a world in which the benefits of global diversification are higher."

Putting Portfolios Together when the World is Falling Apart (Acadian)

Why hasn’t private equity liquidity recovered alongside public markets?

"Unlike prior periods of low distribution rates, today’s lack of private equity liquidity does not correspond with an economic recession and thus there is no clear path back to ‘normal’ like those that previously tracked a broader economic recovery."

 
The Persistent Private Equity Distribution Drought (Meketa)

Is the economic life of AI hardware shorter than its accounting life?

"The point is not that a GPU fails after three years but that its ability to earn excess returns may fade well before its accounting life ends. Economic obsolescence precedes physical obsolescence by several years."

When Will AI Be Both Powerful and Profitable? (Research Affiliates)

What's driving redemption activity in semi-liquid private credit funds?

"Redemption activity in non-traded BDCs does not appear to be driven by investment performance. Many of the larger BDC vehicles produced high single digit returns last year, which compares favorably to a range of fixed income alternatives. Redemptions reflect other factors, including investor liquidity needs and a broader reassessment of portfolio positioning, rather than dissatisfaction with how the underlying assets have performed."

Private Credit and BDCs: Why the Sell-Off Tells an Incomplete Story (Neuberger)

Are emerging markets becoming the picks-and-shovels trade for AI and the energy transition?

"In our view, this new environment is likely to elevate the value of emerging markets’ generous mineral endowment and also give emerging economies more leverage to capture value."

Emerging Markets are in Pole Position in the Resources Race (Robeco)

Is the next challenge in GP-led secondaries finding quality over quantity?

"The market remains structurally undercapitalized relative to the opportunity set, which is positive for secondary buyers. The GP-led capital overhang multiple stands at approximately 1x, compared with around 2x for global private equity, suggesting greater buyer selectivity and reduced pricing pressure."

Not All Private Equity GP-Leds Are Created Equal (StepStone)

Can managed futures benefit from rising geopolitical risk?

"We find that increases in geopolitical risk are generally associated with weaker equity performance, mixed fixed-income returns, and positive energy and U.S. dollar performance, consistent with risk-off dynamics. Extending the analysis to investment strategies, most hedge fund approaches, especially those with long equity exposure, tend to underperform during these periods. In contrast, Managed Futures strategies have historically exhibited more favorable returns when geopolitical risk is increasing."

Navigating Geopolitical Risk: Evidence from Markets and Managed Futures (AlphaSimplex)

Do tax-aware long-short (TALS) strategies require alpha to justify their complexity?

"A 130/30 strategy effectively leverages the manager's stock-selection skill. If the manager lacks skill, the extension increases costs without generating incremental alpha. To test this premise, we re-run the 130-30 TALS strategy with alpha values of 1%, 2%, and 3%. Alpha improves both ending portfolio values and the availability of tax loss harvesting opportunities."

Don't Let the Tail Wag the Dog: The Need for Alpha in Tax Loss Harvesting Strategies (Burney Advisor Services)

Are beaten-down software stocks bargains, or AI value traps?

"At first glance, the selloff may seem like a blanket bargain. However, our intangible value framework points to a more selective conclusion: the software sector exhibits wide dispersion, with some firms positioned to survive and thrive and others at risk of becoming value traps."

 AI Disruption: Moats and Value Traps (Sparkline Capital)

What happens to diversification when inflation breaks the stock-bond relationship?

"None of this is to say that bonds have no role in portfolios. The 60/40 portfolio has endured as the bedrock of asset allocation for good reason. US Treasuries, for example, have offered deep liquidity, negligible credit risk and a historical tendency to rally during growth shocks. But this diversification benefit is not unconditional."

The Inflation Diversification Problem (Man Group)

Is the total portfolio approach (TPA) to investing more mindset than label?

"A total portfolio perspective or mindset is important: we’ve shown it can deliver substantial and practical benefits and help investors to avoid common biases. The TPA label is probably less important, but each institution should recognize the organizational steps it needs to take to embed the mindset and harvest the benefits most effectively."

Total Portfolio Approach: A Quant Lens (AQR)

What separates luck and skill in direct lending?

"In many cases, a healthy fear of making bad loans was replaced by a fear of missing out. In that environment, discipline eroded and increasingly aggressive structures and underwriting became more common."

What Questions Should Allocators Ask When Evaluating Direct Lending Managers? (Silver Point Capital)

Are secondaries becoming the circulatory system of private markets?

"What was once considered a niche rebalancing mechanism has evolved into a structural component of portfolio management. Dedicated secondary capital, the rise of GP-led transactions, and longer holding periods have transformed secondaries into an increasingly central channel through which private market liquidity circulates."

The Road to a $1 Trillion Secondary Market (Seine Capital)

Is the physical economy once again a focal point of portfolio construction?

"The bigger societal issue here is that an ever-greater share of activity (either measured in economic terms or as a share of mankind’s time) appears to happen online, in a fashion seemingly disembodied from the physical world. This is, however, a veneer. In fact, our consumption of physical stuff is greater than ever."

Commodities, Real Assets and the Return of the Physical Economy (AllianceBernstein)

Are portfolios still built for a regime that may have just ended?

"This is the rearview mirror problem. Investors are still using the conditions that shaped the past 15 years as a guide for what comes next, even as that backdrop becomes less dependable. We made a similar point in early 2000, when we warned that apparent diversification had been undermined by a shared dependence on US technology exposure."

VantagePoint: The Rearview Mirror Problem (Cambridge Associates)