Is Your Alpha Big Enough To Cover Its Taxes?

Introduction & Abstract

A great deal of capital and intellectual energy has been invested over the years in seeking to improve the efficiency of the portfolio management process. But most of this effort has been directed at tax-exempt investors (e.g., pension funds, foundations and endowments), even though approximately two-thirds of marketable portfolio assets in the United States have owners for whom taxes are a major consideration.1 Individuals, either directly or through mutual funds, and insurance and holding companies are particular cases in point, but their assets are too often managed with a blind eye to the tax consequences of the management style.

As Garland [1987], one of the few commentators on this subject, reminds us: “Taxes are the biggest expense that [many] investors face –more than commissions [and] more than investment management fees.” Brealey [1983] commented that “return is likely to depend far more on the risk the fund assumes and more on its tax liability [emphasis added] than on the accuracy of the analysts forecasts.” We shall demonstrate here that, for many investors, taxes are clearly the largest source of portfolio management inefficiency, and thus of mediocre investment returns. This is the bad news. The good news is that there are trading strategies that can minimize these
typically overlooked tax consequences.

The intriguing but troublesome aspect of taxes, which obviously diminish investment returns, is that they are generated by the very activity that is intended to enhance returns, namely, turnover. Portfolio managers sell one holding and buy another solely because they believe this activity will result in an economic benefit to the owner, which is to say they believe the trade will produce more wealth than if they simply held a static portfolio. In simplified portfolio management parlance, this expected economic benefit from trading is known as alpha.

As the title proposes, our purpose here is to question whether the typical active manager’s alpha is large enough to cover not only fees and trading costs, which affect all investors, but also –for taxable investors– the taxes that this turnover begets. We will offer both theoretical and empirical evidence that suggest quite clearly that the answer is generally –though not universally– negative. Because the preponderance of evidence is so convincing, we conclude that the typical approach of managing taxable portfolios as if they were tax-exempt is inherently irresponsible, even though doing so is the industry standard.

Taxable investors should bear two simple points in mind. First, passive indexing is a very difficult strategy to beat on an after-tax basis, and therefore active taxable strategies should always be “benchmarked” against the after-tax performance
of an indexed alternative. Second, while active management can conceivably add value on an after-tax basis, this will only occur with careful planning that results in maximizing the build-up of unrealized capital gains.

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