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Tax Alpha

2011 July 19
by Jarrod

In 2003, I became very interested in the additional value added that is possible for an investment advisor or manager who pays careful attention to improving after-tax results.  The presentation below followed the subsequent publication of a paper written jointly with my friend Jeffrey Horvitz.



Insights Into Taxable Investing




March 16, 2004

Jarrod Wilcox



Realistic Study of

Taxable Stock Returns for Private Investors

  • Key paper: Jeffrey & Arnott  “Is Your Alpha Big Enough to Pay its Taxes?” (JPM ’93)

  • More recent studies by Arnott et al., Brunel, Garland, Jacob, Stein, Reichenstein but still…

  • Some lack of clarity about sources and full extent of tax alpha available under realistic conditions.

  • And still too little practical impact on active managers. 

  • My presentation is based on joint study with Jeffrey Horvitz:  “Know When to Hold ‘Em and When to Fold ‘Em” Journal of Wealth Management, 2003.

  • We quantify the current US benefit of:

                    Avoiding short-term capital gains treatment.

                   Waiting longer to realize long-term capital gains.

                   Selling the lowest tax liability tax lots first.

                   Holding stocks until death.




Our Research

  • Bootstrap study of 1000 simulated histories using monthly dividend yields and price returns of S&P500 1926-2001.

  • Realistic payment of short-term, long-term capital gains, loss carryforwards, liquidation and estate taxes where relevant.

  • Up to 600 tax lots over 50 years in each history.

  • Tax alpha here is difference (from tax-insensitive portfolio with 100%/12 monthly turnover) in annualized after-tax return through liquidation and final tax payment – includes 0.25%
    one-way trading cost differences.

  • Conservative – restricted to a single index-like stock.






Tax Alpha as a Function of Turnover and Time to Liquidation




Benefits of Deferring Gain Realization – Median Results

You see the benefit of deferring short-term capital gains taxes right away.

But the benefit of further deferral of long-term gains is very slow to build

A non-linear process requiring very little turnover and not too much dividend reinvestment.

Some benefit to index funds or to corporate investors at 35% tax rate.





Distribution of Bootstrapped ResultsAnnualized Tax Alpha




 Effects of Holding Period and Selective Turnover




Tax-Sensitive Sales

  • At any given turnover rate, selling tax lots with lowest tax liability first

                    Greatly accelerates buildup of unrealized gains, leveraging current liquidation value

                    And accelerating the buildup of tax alpha with deferral of liquidation

                   Making long-term gains deferral much more valuable.

  • With this policy, even fairly high annual turnover rates can result in build-up of tax alpha…

  • Because age distribution of portfolio bifurcates, and a buy-and-hold sub-portfolio is created while…

  • Another high turnover sub-portfolio creates tax benefits.




 After Estate Taxes and Step-up in Cost Basis




Impact of Cost-Basis Stepup at Death

Heirs and charities benefit greatly from the avoidance of all gains taxes, even after estate taxes are taken into account.


If you care about avoiding taxes after death, don’t sell stocks with net gains.




Implications for Active Management

  • Alpha generated for non-taxable investors is often useless to taxable investors.

  • You are unlikely to improve on available tax alpha unless you design your active process to complement it. The hurdle is significant, and bigger than shown here.

  • Realizing no net short-term gains or selling a few deep losses at year-end will not be enough for informed large private investors.

  • Hedge funds that throw off short-term gains for private investors face an uphill battle.