After-Tax Benchmarks: Easier Said Than Done

After-Tax Benchmarks: Easier Said Than Done

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Jennifer Sireklove, CFA

Managing Director, Investment Strategy

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Unlike pretax performance, after-tax performance is unique to each investor’s tax situation and asset flow patterns. That’s why customized portfolio benchmarks are crucial for putting investors’ after-tax performance in perspective.

Are you beating the market after taxes? It seems like a simple question, but it’s not so simple to answer. Measuring performance before taxes can be done in the blink of an eye with some easy arithmetic, as long as you have returns for your portfolio and a commonly referenced index. But when you’re measuring performance after taxes, there’s no such reference point. If you want to know how you performed after taxes, you would need to calculate your own personal index—not a simple task.

This lack of information is the biggest reason many investors are left in the dark about the tax efficiency of their portfolio. Let’s explain why after-tax performance is so mysterious and what to do about it.

How do you calculate after-tax performance? 

There are three key things that determine a US investor’s after-tax performance: 

  • Tax rate
  • Timing of contributions or withdrawals
  • Unrealized gains or losses in each security, which depend on the timing of their purchase 

Every time a security is sold, an investor must pay tax on the difference between the purchase price and the sale price. If the sale price is greater than the purchase price, the investor owes tax. If the price is lower, they have a loss they can use to reduce capital gains or up to $3,000 of ordinary income. Anything they can’t use in the current tax year can be carried forward to future years. 

Why aren’t there ready-made after-tax benchmarks?

None of these things translate easily to a standardized benchmark. Even if the benchmark matched the investor’s tax rate, it would be quite challenging to create enough permutations for it to anticipate the exact timing of each security purchase or sale for any given investor. Never mind the poor investor’s job of trying to sort through all the variations to find the one that matches their situation. But without that, the after-tax benchmark is as good as useless.

Consider a fully invested portfolio in which most of the securities have unrealized gains. A withdrawal from that portfolio would require selling securities, which would likely result in realizing gains. The magnitude of those gains depends on how greatly the securities had appreciated since the original purchase.

How should we frame the benchmark? If it doesn’t have commensurate embedded gains in its holdings, the tax on a hypothetical sale of a security in the benchmark would trigger a smaller tax bill. If you measured a portfolio with many unrealized gains against a benchmark without them, the portfolio would always look worse than its benchmark on an after-tax basis. But this would have nothing to do with the manager’s skill at managing withdrawals in a tax-efficient way—just a mismatch in assumptions around the timing of the original purchases. In other words, even though there are better or worse ways to choose which securities to sell, it’s hard not to trigger any taxes when all you have to choose from are securities with unrealized gains. If the benchmark doesn’t trigger the same gains because it doesn’t have similar embedded gains, it would be misleading to represent it as though it were simply managing realized gains better. 

Similarly, if the portfolio had large and widespread unrealized losses, its after-tax returns might look much better than an after-tax benchmark without those same unrealized losses. This doesn’t necessarily mean that the manager was especially clever at tax-efficient trading. It only means they were up against an easy-to-beat reference point.

Parametric Tax Management

After-tax performance illustrated

In the table below, we calculate the after-tax returns for two benchmarks that differ only in their initial unrealized gain or loss, using a few generalized assumptions about pretax return and turnover. After-tax benchmark 1 starts the period with an unrealized loss, and after-tax benchmark 2 begins with an unrealized gain. During this period, the underlying securities for both benchmarks experience a total return of 1.85% before taxes, with 0.17% of that attributable to dividends. Turnover is 0.38%, and we assume dividends and capital gains face a 23.8% tax rate.

benchmark table

Source: Parametric. After-tax benchmark performance is hypothetical. The after-tax benchmark performance calculations are examples provided for illustrative purposes. Returns do not reflect the deduction of management fees or transaction costs.

As you can see, benchmark 1 triggers a tax loss that can be used to offset other taxes, and benchmark 2 triggers a tax bill. We calculate this by multiplying the turnover figure for the period by the end-of-period unrealized gain or loss position. This produces a tax drag of only -0.01% for benchmark 1 compared with -0.08% for benchmark 2. If the manager’s tax-management skills were being evaluated, they would prefer to be measured against benchmark 2, which looks worse after tax than benchmark 1. But that would be appropriate only if one were managing a portfolio with comparable unrealized gains. If one were managing a portfolio with unrealized losses, benchmark 1 might be the more appropriate reference point.

The bottom line

As you can see, benchmarks are just as essential for evaluating performance after tax as they are before tax—but they must be constructed carefully. This is why the United States Investment Performance Committee After-Tax Performance Standards recommend creating an after-tax benchmark for each investor that reflects their particular cash flows. This is no small undertaking, but it’s essential for any manager who wants to look credible in the tax-management space, and it’s certainly more feasible with skillful deployment of technology. 

Every taxable investor deserves a benchmark as unique as their tax-managed investment approach. There’s no better yardstick for measuring after-tax performance than a customized benchmark. Creating a thoughtful simulated benchmark allows an investor’s portfolio performance to be put in proper perspective, making it possible to measure the success of active tax management. 

For a fuller perspective on benchmarking after-tax performance, download our whitepaper.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.