Research Affiliates: Is Your Alpha Big Enough To Cover Its Taxes?

June 20, 2018

Key Points

  • Deferring taxes is like receiving a free loan from the government.
  • The tax burden can be reduced by limiting turnover, reducing dividend yield, and investing in smaller, more-tax-aware funds.
  • Smart beta has emerged as an investment category with the potential to deliver positive alpha after fees and taxes.
  • Exchange-traded funds provide tax efficiencies that mutual funds lack.

Introduction
Costs matter to every bottom line, and investment management is no exception. Costs—both implicit, such as trading-related market impact costs, and explicit, such as management fees and stated trading costs—lower bottom-line investment returns, and one of the largest costs for any taxable investor is taxes. In the seventh article of our advisor series, we discuss how to identify tax-efficient managers and describe the investment vehicle structures best designed to deliver after-tax alpha. This article draws substantially on the Spring 2018 Journal of Portfolio Management article of the same title written by Rob Arnott, Vitali Kalesnik, and Trevor Schuesler.

Twenty-five years ago in the article “Is Your Alpha Big Enough to Cover Its Taxes?” Tad Jeffrey and I published our findings on the impact taxes have on investment returns. We called this ever present burden on investors “tax alpha,” which is reliably negative. The good news, however, is that now, as then, the tax burden arising from realized capital gains and dividend income is surprisingly easy to shrink. Diligence in deferring capital gains, loss harvesting, lot selection when selling, wash-sale management, holding period management, and other tax-aware strategies can substantially lower the government’s cut of investors’ returns and allow investors to keep more of what their portfolios have earned.

Since 1993, a growing awareness by managers of the importance of tax efficiency, new investment strategies such as smart beta, and innovative investing structures such as exchange-traded funds have all improved investors’ ability to reduce the tax bite into investors’ returns. But other things haven’t changed over the last 25 years. Active managers still have a hard time consistently generating pre-tax alpha, and the fees of active managers are still high. Therefore, for investors to earn the highest possible after-tax return, they and their advisors must consider all additions to, and subtractions from, the following equation:

Gross-of-Fees Return

– Fees

– Income Tax on Dividends and Capital Gains Tax

– Capital Gains Tax After Liquidation

= After-Tax Return

Consequently, an advisor’s ultimate goal should be to shrink the tax-alpha drag on their investors’ portfolios without forfeiting pretax alpha!

Our Findings, A Quarter-Century Ago
Jack Bogle pointed out in 1997 that unrealized capital gains are akin to a free loan from the IRS: deferring the tax liability on a capital gain allows it to grow undiminished to the investment horizon. All else equal, the larger the deferral, the larger the after-tax benefit for the taxable investor. One way to maximize the deferral is to limit portfolio turnover. Turnover is a powerful predictor of a strategy’s tax efficiency because most turnover creates a taxable gain when a security is sold. Investors pay taxes on those realized gains, losing the opportunity to earn a profit on the taxes they paid and did not defer.

Understanding that a positive relationship exists between the size of a portfolio’s unrealized gains (the gap between cost basis and market value) and its pre-tax terminal market value, Tad Jeffrey and I analyzed how turnover affects the after-tax market value of a portfolio. One of our most profound findings was that the marginal impact of taxes is most severe at very low rates of annual turnover. When we assume a starting portfolio value of $100, 6% annual portfolio price appreciation over a 20-year investment horizon, and a 35% capital gains tax rate (similar to current short-term capital gains tax rates, often triggered by the high turnover rates of many mutual funds today), we see that terminal after-tax wealth falls $58 from $320.70 to $262.70 as annual turnover moves from 0% to a low 10%. That loss is larger than the nearly $48 decrease ($262.70 less $214.90) in terminal after-tax wealth when turnover increases from 10% to 100%!

 

For a larger view, please click on the image above.

 

What our research also found was that beating the benchmark is difficult for active managers, after considering fees, and even more difficult after considering taxes. Over the period 1982–1991, only 15 of 71 large active equity mutual fund managers outperformed the Vanguard 500 Index Fund (Jeffrey and Arnott, 1993). After taking capital gains tax and income tax on dividends into consideration, the number of outperforming managers dropped to 9. Investors and their advisors must remember that understanding how best to generate pre-tax alpha is critical, but success on that score is for naught if the impact of taxes is ignored or poorly managed.

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