Say Hello to Tax Alpha
Tax Alpha = Excess After-Tax Return – Excess Pre-Tax Return
If you own a broad market ETF, you’re likely to get modest long-run returns in line with the broad market. However, if you buy 100 to 200 stocks in proportions that allow you to mimic the broad market, your pre-tax returns will likely be similar to those of the ETF. You will probably own some stocks that do very well, and some stocks that do not do so well. This resulting dispersion creates opportunity. An additional 1 or 2 percent per year in tax-alpha is possible, and can translate to sizable comparative gains over the long run.
When stocks have a large gain, there are number of strategies investors can utilize to avoid the immediate realization of these gains which of course generally leads to a tax expense.
Continue to hold the asset. This works well if you still want exposure. If you don’t, it might be necessary to hedge exposure or reduce tracking error relative to your target by purchasing diversifying assets.
Contribute the appreciated assets to a Donor Advised Fund (i.e. use it to fund your philanthropy budget and get a tax deduction (subject to certain conditions)).
Contribute the appreciated assets to a Charitable Remainder Trust, or a Charitable Annuity. These mechanisms give the investor cashflow during the life of the beneficiary, after which the remainder goes to charity. This will not always eliminate the Capital Gains Tax exposure, but it can significantly defer the tax expense while also giving the investor an immediate tax deduction.
Worst performing stocks can be sold to realize tax losses, allowing investors to neutralize certain taxable gains from other parts of their household portfolio. Tax-loss harvesting should be done often (monthly harvesting is recommended).
Select a Target. Typically, we create an indexing portfolio that closely tracks the S&P 500 using a sample of 100 to 200 stocks. However, we can track almost any index. We can also track a customized Twende model portfolio. We do this by optimizing security weighting to achieve similar economic exposure to stock sectors, smart beta factors, currencies, commodity prices, and other variables. Investors can also choose tax targets (e.g. achieve $100k in realized losses by the end of the year while still tracking the S&P 500 and keeping tracking error below 2% per year.
Create a Starting Portfolio. As a starting point, we can utilize any combination of an existing portfolio (perhaps one that already has a complex mix of unrealized gains and losses), and a starting portfolio that we create from scratch. We do this by creating a high-graded sample of the index we are looking to track.
Optimization and Tracking Error Management. We make trades using optimization software with the aim of achieving desired outcomes:
Minimize tax liability or achieve desired tax loss realization
Minimize tracking error or keep it below a preset threshold (e.g. 2%)
Minimize trading costs or keep them below a desired threshold.
Our “buy list” is key to this optimization process. We select replacement securities from this list after sale transactions in order to achieve the above objectives. Buy lists can be customized and may include the following:
An updated “high-grade” list.
Any stock on the target index
Hedging securities such as a short sector ETF