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Why Investment Taxes Are Such a Drag

Rey Santodomingo photo

Rey Santodomingo, CFA

Managing Director, Investment Strategy (emeritus)

What’s the value of tax-managed investing?

It’s funny, because it’s something we pioneered and have been doing for our clients for more than 25 years, but we still get this question a lot. The answer is simple: Tax-managed investing can be of immense value. In fact, thanks to relatively high capital gain rates, investment taxes can represent a larger drag on investment returns than fees or trading costs. The timing of cash flows and the gains or losses embedded in the portfolio can also affect the amount in taxes investors owe. 

Yet despite advances in tax-management theory and practice, many managers continue to ignore investment taxes. Instead they focus exclusively on pretax performance and are reluctant to report after-tax performance. For these managers the pretax alpha they generate isn’t large enough to cover the tax consequences of pursuing the excess return.

What causes tax drag?
Portfolio turnover—the very activity designed to enhance returns—is, ironically, the primary cause of tax drag. The portfolio manager sells one asset, potentially incurring a tax obligation, and buys another based on the belief that the trade will benefit the investor. In many cases, however, the tax incurred turns out to be larger than the (unknowable) additional return potential of the trade. When we evaluate the impact of taxes on investment outcomes, it makes sense to question whether the average manager’s alpha compensates for the tax repercussions. 

Of course, to be effective, tax-management techniques must be applied in context. Just as the mechanics of trading matter, the vehicle selected to implement an investment strategy has important ramifications for a taxable investor. Let’s look at a few of the most common choices.

Choosing a tax-efficient vehicle 
Hedge funds typically use a partnership structure in which the investment manager is the general partner and the investors are limited partners. Gains and losses incurred in the portfolio flow through to the limited partners. However, typical hedge funds are tax inefficient as a result of their tendency to generate high turnover. 

Investors in mutual funds, as the name implies, must share the taxable consequences of actions taken by others within a commingled vehicle. Fund managers can actively harvest losses, but those losses can be used to offset gains generated only within the fund; they can’t be passed through to individual fund holders. 

As with mutual funds, ETF managers can match gains with losses within the fund. Unlike with mutual funds, the ETF manager can leverage the ETF redemption or creation process for further tax efficiency. Thus, in practice, ETFs are generally a more tax-efficient choice than mutual funds. 

Yet there are structural issues with ETFs that make them less than ideal for many high-net-worth investors, for whom a tax-managed SMA may deliver the same diversified, index-like exposure while offering increased after-tax returns. Parametric research has shown that this return advantage can be 1.0%–1.5% over the long term on an after-tax, after-fee basis. Tax-managed SMAs also allow greater control over the underlying securities, which can help make portfolio transitions more tax efficient, enable customization to reflect an individual’s investment objectives, and take into account responsible investing goals. 

When the vehicle is a separate account, investors can use realized losses on the sales of individual securities to offset gains in their equity portfolio—or outside it (from the sale of property, for example). If taxpayers have other goals or priorities, such as the desire to match gains and losses, accelerate the realization of gains, transition assets, or gift specific tax lots to charity, they can do so without structural limitation in a separate account. In these ways the separate account offers investors the most opportunities for tax efficiency. 

Tax Drag image

Tax-advantaged core bond market exposure

Measuring the impact of tax management
The ability to measure the impact of investment taxes objectively is a critical component of a tax-efficient investment strategy. Attributing after-tax performance to a manager’s tax-management skill requires an after-tax benchmark.

A manager's potential tax alpha - the difference between the after-tax and pretax excess returns of the portfolio versus the benchmark - depends largely on that manager’s ability to do two things: take advantage of loss opportunities and avoid gain realization. The level of a manager’s tax alpha depends to some extent on market volatility. The higher the stock-level volatility, the more likely a particular stock will fall into a loss position over a given time period. In a real-life scenario, where portfolios experience both market movement as well as dispersion between stocks, tax alpha is maximized when markets are falling and dispersion between stocks is high.

Yet the value of tax management is more than a measure of tax alpha. While loss harvesting allows us to reduce taxes in earlier time periods, the economic impact of these reduced taxes grows over time. By not only looking at tax alpha but also being mindful of the compounding effect of deferral, we can measure the entire all-in value of tax management.

The bottom line
There’s material benefit to paying attention to taxes, choosing the right investment vehicle, and harvesting losses throughout the year—all things that help make investment taxes less of a drag. 

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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. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.