Tax Alpha - Measure Stick and Coins

Tax Alpha: How to Measure and Maximize

Many investors are looking for more tax-efficient ways to invest. That sounds great in theory, but how do you know if it’s working? While managers can harvest losses, either annually or on a continuous basis, as part of a tax-management process, measuring the actual value to your portfolio is not always apparent. One way to quantify the effectiveness of tax management is by using tax alpha.

Measuring tax alpha

Parametric defines tax alpha as the portfolio’s excess after-tax return, relative to its benchmark, adjusted for any excess pre-tax returns. 

Tax Alpha = Excess After-tax Return – Excess Pre-tax Return 

Over the long term, excess pre-tax returns should be close to zero, but they can fluctuate during shorter time periods because opportunities for tax-loss harvesting can vary. Subtracting this “noise” allows us to more accurately capture the impact of active tax management. 

This also ensures that tax alpha is not swayed by the portfolio’s pre-tax outperformance or underperformance, since neither is relevant in terms of the value of tax management. Simply put, tax alpha is positive only if the excess after-tax return is greater than any excess pre-tax return. In periods with no excess pre-tax return, tax alpha is simply the excess after-tax return.

Maximizing tax alpha

The size of tax alpha depends on two key factors: The direction of the overall equity market and the magnitude of individual stock volatility. 

All else being equal, a falling market increases the probability of losses in an investment portfolio and a rising market decreases that probability. So in falling markets, there are more opportunities to harvest losses and, thereby, increase tax alpha. 

By holding market returns steady, we can observe how stock volatility makes an impact on tax alpha. The higher the stock-level volatility, the more likely that stock will fall into a loss position over a given period. Perhaps most notable is that in our observations, tax alpha was always positive and, in fact, was still meaningful even in periods of strong market performance and moderate volatility.

In a real-life scenario, one where portfolios experience both market movement and dispersion between stocks, tax alpha is maximized when the markets are falling and dispersion between stocks is high. 

Impact of Volatility on Tax Alpha

Source: Parametric

Simulated results are hypothetical and are provided for illustrative purposes only. They do not reflect the actual experience of any investor or Parametric strategy. The simulated results are based on inputs made by the user regarding the initial portfolio value, expected volatility and market rate of return over a 10-year period. The simulation assumes quarterly rebalancing. Simulated returns reflect the reinvestment of dividends and other earnings and include the deduction of advisory fees (0.35%) and transaction costs (0.10%). For an example of actual Parametric after-tax performance results, please refer to the "What We Deliver" graphic on the Custom Core home page. The highest federal income tax rates are assumed in this simulation (43.4% for short-term gains and 23.8% for long-term gains). CA or NY state taxes may also be included, if selected by the user. The assumed market rate of return is not guaranteed. There are risks associated with investing including the risk of loss not reflected in this illustration. An investor should consider his/her current and anticipated investment horizon and income tax bracket when making investment decisions. See Disclosures for additional information.

The bottom line

Tax alpha can be an effective way to measure the value of active tax management and there are scenarios where it can be maximized. However, every investor’s circumstances and objectives are unique. That being said, over our three decades of tax-management experience, we think tax alpha can help to not only illustrate the potential outcomes of active tax management, but also to set realistic expectations based on the market environment.

Potential Parametric solution

Our Custom Core® Strategies let investors take charge of their passive mandates. Since our portfolios are held as separate accounts, we can customize them to meet client needs. Investors can select from a wide range of benchmarks and then tailor their exposure to incorporate their unique objectives.

Rey Santodomingo

Rey Santodomingo, CFA, Managing Director of Investment Strategy

Rey is responsible for all aspects of Parametric’s tax-managed equity strategies. As one of the primary strategists for Custom Core®, he works closely with taxable clients and advisors to design, develop, and implement custom portfolio solutions. Prior to joining Parametric in 2008, Rey was a vice president in product management at MSCI Barra. He earned an MA in financial engineering from the University of California, Berkeley, and a BS in chemical engineering from the University of California, Santa Barbara. A CFA charterholder, Rey is a member of the CFA Society of Seattle and a prior board member of the CFA Society of Seattle. He has also served as an adjunct instructor at Seattle University's Albers School of Business and Economics.

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.