“Is your alpha big enough to cover its taxes?”
Tad Jeffrey and Rob Arnott posed this question 25 years ago in a paper highlighting the negative impact taxes have on investment returns. Since their research was published, multiple tax-aware strategies—from tax-loss harvesting to deferral of capital gains—have become commonplace tools to help investors address the challenges of generating tax alpha.
But a quarter of a century later, one investment strategy has yet to be associated with tax-aware investing: global tactical asset allocation (GTAA). While GTAA can improve returns over buy-and-hold strategies, more tactical trading, when profitable, can lead to higher tax bills—swamping GTAA’s alpha with increased taxes as a result of higher portfolio turnover. As a result, many investors instead embrace buy-and-hold portfolios, where low turnover means a smaller tax bill.
However, research I recently conducted in partnership with Arnott and his colleagues at Research Affiliates, published in December in the Journal of Portfolio Management, shows that abandoning GTAA in favor of reduced taxes may be an overly simplistic response. Instead investors can harvest GTAA alpha—as long as taxes are managed.
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).