Taxable investors are right to be concerned with evaluating performance on an after-tax basis. However, accurately measuring tax efficiency requires a specialized approach.
Putting portfolio performance in perspective is important for all investors. After all, it’s not just the portfolio’s performance in isolation that matters but also how it performed relative to a benchmark. For taxable investors there is usually an important piece missing: the effect of taxes, both on the portfolio and on the benchmark. Without this information taxable investors can’t know the true answer to how their portfolio performed, and they can’t assess the value of any tax management. In a recent blog post, we explained how tax management works; in this article we explain how to measure its value.
Even if it’s commonly overlooked, calculating returns after taxes for an investor’s portfolio is fairly straightforward: Just subtract any taxes on realized gains and dividends in the period from the pretax total return and divide by the original market value of the portfolio. Much less straightforward is calculating this for the benchmark. The benchmark itself has no notion of taxes, which are all investor specific, so a hypothetical after-tax benchmark must be constructed that applies the investor’s tax rate and cost basis to the securities in the benchmark, then mimics any new flow of cash or securities to maintain comparability.
As you can see, all these factors are unique not only to each investor but to each portfolio. This means a custom after-tax benchmark must be constructed for each portfolio to provide an accurate comparison. For example, consider a portfolio with large and widespread unrealized gains. If an investor makes a substantial withdrawal requiring the sale of securities and realization of gains, it would be unfair to measure the after-tax returns of this portfolio against a benchmark with no such withdrawal and no unrealized gains. Conversely, the after-tax returns of a portfolio with large and widespread unrealized losses might look better than warranted if measured against a benchmark without those characteristics as well.
Measuring tax alpha
Once an after-tax benchmark has been constructed, it’s possible to evaluate portfolio after-tax returns relative to the after-tax benchmark. But again, some nuances apply. In particular, one must make sure to adjust for any differences in pretax returns between the portfolio and benchmark. This means a true measure of tax alpha is actually the excess after-tax return minus the excess pretax return.
Tax alpha = excess after tax return – excess pretax return
Excess after-tax return = after-tax returnportfolio – after-tax returnbenchmark
Excess pretax return = pretax returnportfolio – pretax returnbenchmark
Now, if the excess pretax return is zero, tax alpha is simply the after-tax return for the portfolio minus the after-tax return for the benchmark. In reality, most portfolios perform slightly differently from the benchmark on a pretax basis even in well-managed direct indexing portfolios. This is because each direct indexing portfolio typically needs some flexibility in its holdings to provide tax management.