The Internal Revenue Service plans this year to rule on whether arbitrage investment strategies involving short sales of securities might result in taxable income for tax-favored investors.
But pension funds and endowments, which have been pressing the IRS for guidance on the matter since the late 1980s, already have plunked billions of dollars into high-yielding investment strategies built around shorting stocks.
Estimates of how much tax exempt institutions have invested in arbitrage strategies that involve shorting securities range from $10 billion to $36 billion.
IRS guidance on short sales of securities could dramatically alter investment strategies used by pension funds, endowments and other tax-free institutional investors by validating market neutral and other hedging strategies. On the other hand, if the IRS rules income from shorting strategies is subject to unrelated business taxes, it could upset the billions of dollars institutions already have in such strategies.
"A presumption has been that when the IRS issued a statement it would be favorable," said William Jacques, chief investment officer at Martingale Asset Management, Boston, which invests about half of its $400 million under management in market neutral strategies.
Although shorting implies speculative bets on falling stock prices, institutions generally short securities as part of market neutral investment strategies that use sophisticated mathematical models to profit from both winners and losers - purchasing winning stocks and simultaneously shorting a corresponding value of losing stocks.
If properly constructed, such portfolios can produce handsome returns by eliminating market swings, and relying solely on the stock-picking skills of the models. Institutions also are significant players in hedge funds - that take large calculated bets on the prices of commodities, stocks, and other securities.
Apart from the tax question, short selling is otherwise not a contentious issue for pension funds. It is widely accepted under the Employee Retirement Income Security Act of 1974, if it is part of a broader, economically sound investment policy.
The IRS, which has been dawdling over issuing guidance since it gave the green light to The Common Fund, Westport, Conn., in a May 1988 private letter ruling, will issue a ruling sometime this year, government officials say.
A private letter ruling can only be relied upon legally by the party that requested it and cannot be used as a legal precedent by others even though it is indicative of the IRS' view.
"We understand this issue and that this issue has been hanging around, and we've made a decision we're going to address it this year," said Glen A. Kohl, tax legislative counsel at the Treasury Department, which includes the IRS.
Mr. Kohl declined to predict when the IRS might issue the guidance or in what form. By one lawyer's estimate, there are at least 18 requests for private rulings on short selling pending with the IRS.
Pension lawyers generally expect the IRS will issue a favorable ruling because the agency approved regulations in 1992 exempting investments in swaps from unrelated business taxes. Swaps have similar tax implications to shorting.
Tax laws require pension funds, endowments and other tax-favored investors to pay taxes on earnings from an unrelated business activity, and on investment income financed with borrowed money.
The IRS must decide whether shorting of stocks - in which stocks are borrowed, sold, purchased at a lower price then returned to the lender - classify as debt-financed transactions under the rules.
In The Common Fund ruling, the IRS exempted short selling from unrelated business taxes if the borrowed securities were secured by an equal amount of cash or Treasury securities with the broker. The IRS concluded that if there was enough money with the broker to cover the shorted securities, it was not "an acquisition of indebtedness."
The Common Fund has about 5.5% of its $18 billion in assets in arbitrage strategies that rely on shorting securities.
"In my analysis, the borrowing is a broker borrowing, not by the client," Louis Marrett, partner in the Boston law firm of Nutter McClennan & Fish.
"Therefore there can be no debt-financed property in the hands of the seller," which would be the pension fund client, said Mr. Marrett.
The Rockefeller Foundation, New York, has invested about $230 million, or 10% of its $2.3 billion investment portfolio, in a market neutral strategy since the late 1980s, said David White, chief investment officer. The foundation - still awaiting a private letter ruling from the IRS on short sales more than five years after it applied - has earned a "decent" annual return in the range of three percent points above than the returns on 90-day Treasury bills through the strategy, he said.
A similar long-short strategy has produced 400 basis points of alpha for the Virginia Retirement System, according to John McLaren, managing director in charge of alternative investments. The fund has $400 million of its $16 billion assets invested in the strategy.
Said David K. Storrs, president of The Common Fund: "Think of an ordinary stock manager. If he can find stocks that will do 2% better than the market, he does that much better. But if he sees stocks that will do 2% worse than the market .*.*. he can short those and deliver 4% returns."
The Common Fund earned 16% through such a strategy last year, compared with a 10.1% return for the Standard & Poor's 500 Stock Index, he said.
Jacobs Levy Equity Management estimates about 80% of the $500 million it manages in market neutral strategies comes from pension funds, endowments and other tax-exempt institutions, said Bruce Jacobs, principal of the Roseland, N.J., firm.
The firm has earned annualized returns of 650 basis points above its benchmark of 90-day Treasury bills since it began using the strategy in 1990, Mr. Jacobs said.
The firm uses three variations of the strategy. The first is a pure market neutral strategy, in which equal dollar amounts are invested in buying and shorting stocks. In the second version, an equal amount also is invested in S&P 500 futures contracts. The third strategy has a varying exposure to equities using futures contracts in addition to the money invested in the market neutral strategy, Mr. Jacobs said.
In the meantime, without clear-cut guidance from the IRS, many institutional investors are relying on the advice of their lawyers, who say shorting stocks, as part of these "long-short strategies," will not result in taxation on their earnings.
"I think there is a general consensus that shorting by itself doesn't lead to unrelated business taxable income. And the best piece of evidence of that is pension funds are increasingly engaging in shorting," said Peter Koffler, general counsel at Twenty-First Securities Corp., New York, which manages about $200 million in market-neutral strategies.
On the other hand, tax-exempt clients of Collins Associates, a Newport Beach, Calif., manager of managers that oversees $1.4 billion in assets, do pay taxes on some of their returns made from market neutral funds, hedge funds and short selling funds using outside managers, said Don Leahy, director.
But the taxes are insignificant, he said. Last year, the taxes amounted to less than 5% of total returns from market neutral, hedge and short selling funds.
Thus, returns from a fund that earned 10% would be shaved to 9.5% after taxes, Mr. Leahy explained.
The firm earned after-tax returns of 14% from its market neutral funds, and 22% and 29.5% from its two hedge funds last year. "Up until now, it's just been a perception issue. You mention UBTI, and you've got pension funds and endowments running scared," Mr. Leahy said. "But when they actually look at the strategies and see whether there is UBTI and how much, it's not that bad."
