Quant hedge fund AQR Capital Management is quietly touting a product that can do something extraordinary and potentially divisive: help slash how much income tax its investors have to pay.

While most tax-optimizing strategies on Wall Street seek to reduce what’s owed on any capital gains, the AQR TA Delphi Plus Fund LLC is able to generate losses that can be offset against income, including from wages and investments. 

The vehicle is complex and available only to an elite tier of clients. But in the right circumstances, it could wipe out a significant portion of an investor’s taxable income—making it a formidable tool for wealthy individuals looking to minimize their tax burden.

“Think about a doctor making a million bucks a year who’s got this crazy portfolio that’s generating all these capital gains,” says Brent Sullivan, an industry consultant specializing in taxable wealth. “The gains get offset with normal tax-loss harvesting, but reducing their ordinary taxable income is the next horizon in tax management.” 

Yet such moves risk bringing fresh scrutiny to a controversial corner of finance, where capital gains-tax strategies are already a magnet for criticism because they usually benefit the richest investors most. A vehicle like Delphi Plus could be even more powerful, since income tends to be more regular than capital gains and is taxed at far higher rates.

Greenwich, Connecticut-based AQR declined to comment.

Delphi Plus Difference
To create a tax-aware investment product, Wall Street begins with an underlying strategy that is itself intended to make money, then adjusts it for maximum tax efficiency. Typically that involves selling losing investments to realize a capital loss, which can be deducted from a capital gain to reduce the bill for any appreciated assets. 

Yet that approach does little to mitigate one of the biggest tax burdens faced by many rich Americans. Federal income tax rates for top earners can be nearly double the 20% applied to long-term capital gains, and only $3,000 worth of capital losses can be offset against it in a given year. 

Delphi Plus, a mashup of two longstanding AQR strategies, uses trades capable of creating so-called ordinary losses, which are deductible against income. An AQR presentation obtained by Bloomberg News shows the fund was able to generate ordinary losses amounting to 31% of capital invested in 2023, as well as 4% in short-term capital losses. It returned 12.2% on a pre-tax basis. 

The trades include what are known as notional principal contracts, or NPCs, according to a person familiar with the fund who asked not to be identified discussing the details. An NPC is a swap contract where two parties agree on a series of payments tied to the fluctuations of an asset. The payments are ordinary in nature, which means ordinary losses are generated whenever an investor has to pay their counterparty for a losing bet. But when a position is terminated early, it can be booked as either a capital gain or loss. 

According to Thomas Brennan, a professor at Harvard Law School, that’s possible because swaps occupy a gray area where they are in some ways a capital asset and in others a debt instrument.

“It’s letting people elect and change capital items to ordinary items,” Brennan says of the current rules. In his view that can be worrisome “because in general, the tax system is designed to try to keep capital things in one bucket and ordinary things in another.”

Barriers to Entry
Delphi Plus is roughly four years old, but remains niche. A regulatory filing from July showed it had raised about $487 million in assets—a figure that doesn’t reflect redemptions. The relatively low total (AQR manages more than $116 billion overall) likely stems from its high barriers to entry. 

The strategy is available only to qualified purchasers, a category loosely defined as those with at least $5 million of investments. 

Delphi Plus charges 1.75% of assets and 20% of any profits over a Treasury-bill rate, according to two other people familiar with the strategy who asked not to be identified—close to standard fees for a hedge fund. Like most hedge funds, it’s set up as a partnership, allowing AQR to pass the tax benefits on to its investors, who are considered partners in the business. 

In addition it has been designated as a “trader fund,” an Internal Revenue Service distinction for vehicles that trade heavily and focus on short-term bets, according to the people. In U.S. tax law, that means expenses like management fees, financing costs and dividends paid out on its shorts can potentially be deducted for clients. (Shorting a stock involves selling borrowed shares, and any dividends paid out during the loan period have to be passed on to the lender.) It’s also possible to deduct performance fees, if they are structured as fees rather than an allocation of profits.

In some ways Delphi Plus resembles a classic tax-saving tactic like investing in real estate and claiming losses from maintenance costs and depreciation. But in that case, unless a taxpayer actively takes part in the investment, those losses count as passive and cannot be deducted against active income like wages. 

That’s not an issue with Delphi Plus, since a regulation long ago categorized financial trading in such partnerships as non-passive. (The rule was originally intended to stop an investor offsetting investment income with passive losses.)

Even then, “it’s really hard to understand why—as a policy matter—Treasury and the IRS would want to give this gift to hedge funds and their investors,” says Daniel Hemel, a professor at the New York University School of Law, referring to the active trader-fund tax benefits. 

A spokesperson for the IRS declined to comment on the rules.

Core Strategy
Key to the recent performance of Delphi Plus has been its underlying strategy, which has enjoyed a strong run as the post-Covid market environment buoyed a slew of quant trades.

Seventy percent of its risk-taking goes long profitable stocks with limited swings and short the opposite (“Delphi” was the seat of one of the great Greek oracles, and is a reference to Warren Buffett, who famously likes high-quality shares). The remainder is allocated to trend-following, which rides momentum across dozens of futures contracts.

The product over the long run targets a pre-tax return of 14% and a tax benefit of 8% a year, the AQR presentation shows. It also generates some long-term capital gains and qualified dividends.

Having an underlying investment approach is essential for any tax-optimizing product to withstand scrutiny because trades can’t just exist to create losses, according to Andie Kramer of ASKramer Law.

“If you’re doing something that’s a transaction for tax purposes, then the government doesn’t like it,” says Kramer, who specializes in the taxation of financial products. “They can say: ‘Was there economic substance in the structure?’”

To be clear, it’s not a free lunch. While Delphi Plus has delivered positive pre-tax returns in each of the last three years, an investor could still lose money on the fund overall. The product would have posted negative returns in 2020, 2018 and 2012, according to AQR’s analysis in the presentation. Its tax benefits also aren’t consistent.

It’s unclear how many other strategies generating ordinary losses exist. AQR has at least two more, the people said, including the trend-following TA Helix Fund and the multi-strategy TA Legacy Fund. The latter has raised $682 million, a regulatory filing from last week showed.

Meanwhile Quantinno, a tax-focused money manager founded by an ex-AQR quant, also has a small equities-based vehicle that can generate ordinary losses, one of the people said. The firm declined to comment, citing private-fund regulations.

Historically, hedge funds haven’t tended to market tax-friendly strategies to investors because their clients are often exempt institutions like endowments and pensions. But tax efficiency has been a pet project at AQR for years, and the firm now runs close to $10 billion in tax-optimized long-short strategies for clients. It has authored at least 20 papers on the subject, including detailing the tax benefits of trader funds, for example.

In a webinar viewed by Bloomberg News, John Huss, the co-head of AQR’s macro strategies group, said the research behind Delphi Plus began as an effort to make pre-existing strategies more tax-efficient for the firm’s U.S. taxable investors. That includes AQR employees, with Huss himself benefiting from the strategy, he said.

A regulatory filing from earlier this year showed 3% of assets in Delphi Plus were owned by AQR insiders. For Helix it was 87%, and for Legacy it was 40%.

“We came out and seven or eight years ago said, ‘Hey, let’s do research to see if we can make our after-tax return be the same as our pre-tax return,’” Huss said on the webinar hosted by Symmetry Partners, a third party which was promoting Delphi Plus to financial advisors. “That would’ve been a home run, even if that’s all we had done. And it turns out that we were able to do much better than that.”

This article was provided by Bloomberg News.