The Internal Revenue Service has cleared the way for pension funds, endowments and other tax-favored institutional investors to use investment strategies involving short sales of securities without fear of taxation.
The IRS ruling issued last week could spur investments by tax-exempt institutions in market-neutral investment strategies and other hedging techniques built around shorting stocks.
And for those investors that had already poured billions of dollars into such highly profitable arbitrage investment strategies, the ruling comes as a huge relief.
"The penalty for being wrong on this was so dramatic - the risk-reward relationship wasn't the best as far as many of the fund managers were concerned, so they held back on this," Robert Willens, managing director at Lehman Brothers Inc., New York, said.
Pension funds and other tax-exempt investors could have paid out millions of dollars if the IRS had ruled short selling could trigger unrelated business taxable income. The top tax rate for unrelated business income is 34%, the same as the corporate income tax rate.
"For people who were waiting for final guidance, this will open up another investment tool to use," said A. Richard "Brick" Susko, partner at Cleary, Gottleib, Steen & Hamilton, a New York law firm.
"Our clients have always anticipated this outcome and will be pleased but not surprised," said Bruce Jacobs, principal of Jacobs Levy Equity Management, a Roseland, N.J., firm which manages $400 million in market-neutral strategies for pension funds and other tax-favored investors.
Mr. Jacobs referred to a 1995 edition of a finance textbook by William F. Sharpe, the Nobel Memorial Prize winner and professor at Stanford University, which discusses market-neutral strategies.
"This has been talked about, written about and has appeared in MBA textbooks. Now with this IRS ruling, I would expect a substantial broadening of interest among tax-exempt investors," he said.
This sentiment is echoed by Mark Fichtenbaum, tax director at Twenty-First Securities Corp., New York, which manages about $200 million in market-neutral strategies. "It will be easier now to get pension funds to invest in strategies that involve shorting of stocks," he said.
Several institutions had decided against investment strategies involving short-selling until the IRS issued the last word on the subject. The agency delayed ruling on short sales after initially giving the nod to The Common Fund, Westport, Conn., in a May 1988 private letter ruling (Pensions & Investments, March 21).
Meanwhile, Robert D. Arnott, chief investment officer at First Quadrant Corp., Pasadena, Calif., anticipates tax-exempt investors could double their commitments to market-neutral or other long-short strategies in the next three to four years. First Quadrant, which manages about $9 billion for tax-exempt institutions, already has about $1.5 billion of client money in such strategies.
It is hard to gauge just how much money tax-advantaged investors have poured into shorting strategies, but estimates range from $10 billion to $36 billion.
While basic shorting implies taking bets on falling stock prices, pension funds and other institutional investors usually get involved in short sales of securities through more elaborate market-neutral investment strategies. In such strategies, money managers use sophisticated mathematical models to bet on both winners and losers - simultaneously purchasing stocks they expect to appreciate and shorting stocks expected to fall.
Such strategies can yield handsome profits for investors by eliminating market volatility, and depend solely on the stock picking skills of the managers.
The $16.4 billion Virginia Retirement System, Richmond, aims to earn 400 basis points above the return on 90-day Treasury bills through market-neutral strategies, said Tom O'Donnell, senior investment officer. The fund began investing in late 1991 and has $300 million invested in a domestic equity market-neutral strategy, he noted.
The IRS' ruling also means some tax-exempt investors that have lost money through short-selling strategies no longer can deduct those losses against taxes imposed on any unrelated business income, explained Louis Marrett, partner in the Boston law firm of Nutter McClennan & Fish.
"First you would have to have losses, and second you would have to have income from unrelated businesses, so the question wouldn't come up very oft