“Is your alpha big enough to cover its taxes?”
Putting global tactical asset allocation to the tax aware test
To quantify the alpha generated by tax-aware tactical investing, we studied data from January 1980 through December 2017. We used an array of asset classes, including equities, fixed income, and real estate investment trusts (REITs). We diversified the GTAA strategy across asset classes and used the carry, value, and momentum factors to tactically allocate weights in an unlevered portfolio.
Then we tracked the performance of an equally weighted portfolio (our benchmark), a tactical portfolio (the model), and a tax-aware tactical portfolio (the strategy) for which we managed turnover with the goal of proactively reducing the portfolio’s tax liability.
The results from the paper show that taxes have a major negative impact on returns—over the time period studied, taxes consumed 40% of the real return.
However, we found the extra tax liability created by tactical trading can be more than made up for by tax-loss harvesting. When we adjust for inflation, our most striking result is that the real after-tax wealth creation from the tax-managed GTAA strategy almost doubles that of the equally weighted benchmark.
The bottom line
In a low-yield environment, earning any positive alpha after the effects of fees, inflation, and taxes is a daunting goal, and it has driven investors toward passive and buy-and-hold portfolios. But tactical tax effects can be consciously and reliably reduced. Our analysis shows that investors can capture most of the benefits of GTAA, and even provide a boost to their after-tax returns, by following a tax-aware strategy.
> Raise your awareness: For a deeper look at tactical and tax-aware investing, download the Journal of Portfolio Management whitepaper (subscription required).