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.
After-tax benchmarks
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.
Make taxes less taxing
As discussed in the earlier blog post we mentioned, this flexibility lets the manager do things like hold securities longer to defer gains, select loss-maximizing or gain-minimizing tax lots for trades, move securities into or out of a portfolio in-kind instead of liquidating, and avoid purchases that would disallow losses according to IRS wash-sale rules. All these actions are an attempt to balance delivering pretax portfolio returns similar to the benchmark while maximizing the after-tax benefit to the client. In any given period, there likely will be small differences in the pretax performance of the portfolio and benchmark. A portfolio with a higher pretax return will outperform one with a lower pretax return on an after-tax basis for a given amount of taxes. Subtracting the pretax excess return allows the investor to isolate the value of active tax management and avoid being distracted by any pretax tracking differences.
The following table shows two scenarios in which each portfolio outperformed the benchmark by 0.20% on an after-tax basis. If the story ended there, we might conclude that tax management was equally additive to both. However, what we miss is that the portfolio in scenario A outperformed the benchmark by 0.20% on a pretax basis, and the portfolio in scenario B underperformed by 0.10%. After adjusting for this, we see that tax alpha was actually 0% in scenario A and 0.30% in scenario B. In other words, the tax management was more valuable in scenario B than in scenario A.
After-tax versus pretax return scenarios, net of fees
Source: Parametric, June 2022. This table is provided for educational purposes to show how tax management can be evaluated in different scenarios. Not representative of any client portfolio.
Again, the goal of a direct indexing portfolio is to track the benchmark. The adjustment is not intended to create a benefit from pretax underperformance; it simply allows us to measure true tax alpha regardless of pretax tracking, highlighting the value of tax management.
Another item that can be overlooked when thinking about the value of tax management is the benefit of gains deferral. This allows the investor to retain funds in the portfolio for additional compounded returns. And if they are held long enough, they can be sold at the lower long-term gains rate. Of course, if these securities are removed from the benchmark, this will increase potential pretax performance differences between the portfolio and the benchmark, but this is one of those trade-offs investors might want to make. It’s another example of how adjusting after-tax excess returns by pretax excess returns is a more appropriate measure of the benefit of tax management than looking at after-tax excess returns alone.
The bottom line
Evaluating tax management is a complex but essential task that gives investors a clearer picture of what their portfolios gained. This requires creating a portfolio-specific after-tax benchmark that reflects the investor’s unique tax situation and adjusting the after-tax excess return by the pretax excess return. Equipped with this information, investors will have a true picture of how their portfolio performed after taxes.
