The rip-roaring popularity of a strategy that helps individual investors lower their tax bills is powering an unprecedented borrowing binge.
Charles Schwab said Thursday that margin loan balances on its books had swelled to roughly $188 billion in the third quarter, nearly doubling year over year. A significant driver: Long-short tax-aware strategies that promise to beat the market without paying taxes on all of the capital gains.
Schwab's margin balance included roughly $61 billion related to long-short strategies, according to the company's report. On a call with analysts, Chief Executive Rick Wurster said adoption of the strategy had grown "exceptionally quickly" this year.
"Saving money on taxes is something our clients love to do," Wurster said. "That demand is likely to continue."
Margin debt, or investor borrowing from brokerages to buy securities, has hovered near record highs. What's more, Bank of America and Goldman Sachs each reported this week that their securities-based loans, which include some margin debt as well as other types of loans, have seen double-digit growth in the 12 months through September. Morgan Stanley reported that its margin book grew by more than 10%.
The tax-aware long-short strategy has been a key reason.
Long-short strategies managed by hedge-fund firms such as AQR and Quantinno have raked in nearly $190 billion in assets, up from just over $1 billion five years ago, according to estimates by Brent Sullivan of Tax Alpha Insider, an online publication devoted to tax-aware investing.
The strategies seek to track -- and ultimately outperform -- an index, but also involve borrowing against the portfolio to create two "extensions," one that goes long on stocks and the other that bets against them. The goal is to amplify returns while also creating more opportunities for tax losses to harvest.
Fidelity Investments, which like Schwab is a major custodian of wealth assets, aided the rise of the long-short tax-aware strategy by allowing people with smaller account balances to jump in. The strategy became so popular that Fidelity in February said it was indefinitely pausing the opening of new accounts. The restrictions caused a flood of new assets into accounts at Schwab, leading it to impose its own limits.
In its latest set of restrictions, rolled out last month, Schwab raised the minimum investment for some new long-short tax-aware accounts to $10 million from $1 million, and said it wouldn't enroll new clients or accept new funds in portfolio margin accounts.
The leverage component of the strategy involves taking a significant amount of balance-sheet risk, according to people familiar with the matter. The limits by the two biggest custodians have threatened to curb the growth of the strategy overall, although other custodians have begun accommodating investors who want to do it.
"It was important to us to throttle growth for a period of time to make sure that we can support this from an operational standpoint," Wurster told analysts. Schwab is also working on its own version of a long-short tax-aware product, he said, that will allow the company to offer strategies "in a way that is operationally and financially manageable over the longer term." That would put Schwab in direct competition with AQR and Quantinno.
U.S. margin debt totaled $1.45 trillion in August, according to Finra data, near the record of $1.5 trillion earlier this summer. The growth is driven in part by the mechanics of an ever-rising bull market: As stocks climb, short sellers need to post more collateral to their lenders. That cash can be automatically drawn from a margin loan.
Individual investors have also shown a greater appetite for risk in recent years, piling into products such as exchange-traded funds that can amplify gains and losses. In the second quarter, total assets in leveraged funds blew past $180 billion.
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