Factors and Taxes

As a result of the trading required to capture the premiums that drive factor strategies investors may face significant tax liabilities. The challenge for the portfolio manager is to incorporate tax-efficient trading practices at each rebalance to mitigate tax impacts and ultimately avoid sacrificing excess returns. That is certainly a tall order, but it is achievable and surprisingly profitable.

The authors propose and test a framework for portfolio construction that successfully separates the tax-managed implementation of a factor portfolio from the factor characteristics of the strategy itself. The premise of the framework is that investor views on the factor risk premium are represented by a tax-oblivious model portfolio. The model portfolio is then implemented in a separately managed account (SMA) by utilizing optimized, tax-efficient trading.

To construct factor portfolios, a specific risk model is used within an optimization approach that identifies the implementation trades necessary to maintain desired factor exposures at designated rebalance dates. Then after-tax performance and risk (ok, style) attributes are calculated across a series of simulated portfolios to provide a clear accounting of the tax impact on returns and risk.

Factor Investing for Taxable Investors

• Ben Davis, Tianchuan Li, and Vassilii Nemtchinov
• Journal of Portfolio Management
• A version of this paper can be found here
• Want to read our summaries of academic finance papers? Check out our Academic Research Insight category.

What are the research questions?

1. What tax management techniques are effective in mitigating tax impacts?
2. How are pre-tax and post-tax returns affected by tax management techniques?

What are the Academic Insights?

1. This research documents five tax management techniques that may improve tax efficiency without diminishing pre-tax returns:
   • Manage the holding period or stretch the rebalance dates. Assets held for longer than twelve months qualify for lower long-term capital gains tax rates.
   • Use tax-lot accounting (HIFO) and sell the high-cost shares first to minimize taxable gains.
   • Defer the realization of gains by avoiding the sale of appreciated assets to delay gains.
   • Harvest losses by taking capital losses to offset taxable gains.
   • Avoid wash sales. The IRS disallows the deduction of losses on securities sold and repurchased within 30 days​.
2. The return advantages of factor investing remain intact even after the implementation of tax management tactics. Factor premiums appear unaffected by the use of tax management techniques and portfolio returns may actually be increased on a post-tax basis. Passive benchmark returns are easily outdone post-tax basis. We can safely assume that the impact of the tax drag ordinarily associated with factor strategies can be handled with the proper attention paid at rebalancing dates. Take a close look at the results presented in Exhibit 3 and note the following:
   • Across all eight strategies, SMAs on average outperform the passive benchmark on an after-tax basis, net of management fees and transaction costs.
   • Factor alphas remain positive reflecting the factor premia.
   • There are sizeable performance differences across strategies. Historical factor alphas range from zero basis points (dividend yield) to 240 basis points (value-size-profitability).
   • Model portfolio tax drag detracts from performance for five out of eight strategies
   • Value strategies are among the least tax efficient, with an average tax drag of 64 bps, almost reducing the value pre-tax alpha.
   • Momentum wins with a tax benefit of 24 bps. As momentum keeps winners which defers gains, and sells losers which realizes losses, it is an inherently tax efficient factor strategy. A surprising result given that turnover for momentum portfolios was triple that of value. The degree of portfolio turnover considered singly is not a direct proxy for tax efficiency.
   • SMA tax alphas are more than sufficient to mitigate model portfolio tax drags. SMA tax alphas vary across strategies, partly due to inherent tax efficiency of underlying model trades but also due to differences in the breadth of the benchmark universes, with universes including small-caps having a broader tax loss harvesting opportunity set.

Why does it matter?

Capturing factor premiums is not just a pre-tax conversation between investors and portfolio managers anymore. The results presented in this research establish the feasibility of trading in a tax-efficient manner without sacrificing pure factor return premiums. By showing that tax management can significantly improve after-tax returns, the research encourages a more comprehensive approach to portfolio management that incorporates tax considerations alongside traditional performance metrics.

The most important chart in the paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Abstract

This article sets forth a practical framework for incorporating tax management into long-only factor investing and assessing the impact on tax efficiency and pre-tax returns. The framework premise is that investor views on the factor risk premium are represented by a tax-oblivious model portfolio. The model portfolio is then implemented in a separately managed account (SMA) by utilizing optimized, tax-efficient trading. The authors rigorously evaluate the impact of tax-managed model implementation on expected excess returns and risk on a both a pre-tax and after-tax basis. In particular, they extend the standard framework for covariance-based risk attribution to incorporate expected factor alphas and tax impacts. They find that tax-managed model implementation provides a boost to after-tax returns, more than fully mitigating model portfolio tax drag in most cases. Importantly, they also find that tax-managed model implementation does not degrade the capture of the factor premium, neither eroding the factor alpha nor meaningfully increasing risk of pre-tax underperformance relative to the benchmark.