Figure 1. Relationship between Components of Pre-Tax Return and Tax Costs of a Hypothetical Tax-Agnostic Long-Only and a Hypothetical Composite Long-Short Strategies
We were gratified and humbled by the decision of the Graham and Dodd selection committee of the CFA Institute to award the 2020 Top Graham and Dodd Award to our paper “The Tax Benefits of Separating Alpha from Beta.”
Liberman, Joseph, Clemens Sialm, Nathan Sosner, and Lixin Wang. 2020. “The Tax Benefits of Separating Alpha from Beta.” Financial Analysts Journal 76 (1): 38-61.
In our research, we often focus on tax-aware strategies. However, in this paper, we tackle a different practical question: In a world dominated by tax-agnostic managers, how can investors design their tax-agnostic strategy allocations to improve the tax efficiency of their overall investment portfolios? We show that investors who invest separately in a long-short (tax-agnostic) strategy and an index fund have the ability to achieve higher after-tax returns than those investors who invest in a long-only (tax-agnostic) strategy that utilizes the exact same alpha signals as the market neutral strategy.
The reason for this is simple: Trading stocks in pursuit of investment alpha, a long-only active manager realizes taxes on both the market appreciation and the alpha it adds on top of the market return. On the other hand, a long-short manager realizes taxes only on the alpha it achieves. Therefore, investors who separated alpha investments from beta exposure are able to enjoy the market appreciation (almost) tax free by investing in an index fund. We call the latter approach of combining an index fund with a separate long-short strategy a “composite long-short strategy.”
Figure 1 below 2 2 Close Figure 1 presents the same data as Figure 2 in the paper. depicts the relationship between components of pre-tax return and tax costs of the hypothetical long-only and hypothetical composite long-short strategies. The first things we notice in the chart is a striking difference between the levels of tax costs of the hypothetical long-only strategy and the hypothetical composite strategy for any level of pre-tax return. In fact, we measure the expected tax cost of the hypothetical tax-agnostic long-only strategy to be 1.4% compared to just 0.2% for the hypothetical tax-agnostic composite strategy.
Further, Panel A shows that tax costs of the hypothetical long-only strategy are closely related to the market return, as is evidenced by the highly positive slope of the regression line and a small dispersion around it. Panel B shows that, surprisingly, tax costs of the hypothetical long-only strategy have virtually no relationship to its pre-tax alpha. These results are quite remarkable. They show that the hypothetical tax-agnostic long-only strategy generates tax costs due to its market exposure, an exposure that could be obtained free of tax by investing in an index fund.
On the contrary, for the hypothetical composite long-short strategy, the relationship of its tax costs with the market return is negative (Panel A) and with the pre-tax alpha demonstrably positive (Panel B), meaning that the hypothetical strategy realizes tax costs on its alpha, as it should.
In sum, in a world dominated by tax-agnostic managers, the approach of separating alpha from beta provides a practical solution of reducing an unnecessary tax burden coming from market exposure.
Finally, as a robustness test, we show that tax awareness does not change the relative tax efficiency of the hypothetical long-only and the composite strategies—a hypothetical tax-aware composite long-short strategy achieves a significantly higher after-tax return than a hypothetical tax-aware long-only strategy.
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