Using Tax Alpha to Measure Tax Efficiency
Tax alpha is a measurement of tax efficiency that attempts to isolate the value of active tax management by comparing a manager versus a passive benchmark. This metric is preferred at Parametric over alternative measures of tax efficiency because it shows the investor’s actual tax experience and uses a custom benchmark to put the results in perspective. The primary shortcoming of using alternative metrics such as turnover, unrealized gains, or loss carry forwards is that they can only indicate the investor’s potential tax experience—not their actual experience. Just as an investor with an annual pretax return of 15% might be reasonably pleased by the result until she learned that the benchmark returned 29% in the same period, or a -15% return might actually seem like good news in comparison to -29% for the benchmark, an after-tax return figure is less meaningful without a reference point.
This brief explains how Parametric calculates tax alpha and what we see as the shortcomings of other ways used to measure tax efficiency.