Continue active refreshing of this index's data?

Continue active refreshing of this index's data?

Blog Posts — March 25, 2021

Generate Alpha With Direct Indexing and Active Tax management

by Sercan Yıldız, PhD, Kartik Sivaramakrishnan, PhD, and Zhe Liu, PhD

Qontigo’s Tax-Managed Investing solution enables asset managers to improve post-tax returns through tax savings. Two new whitepapers investigate the benefit of active tax management for investment strategies, focusing on a broad cap-weighted equity market index and on factor-based strategies.

Tax costs represent a severe drag on the performance of taxable portfolios. By taking an active tax management approach to control the impact of taxes, you can improve your portfolio’s post-tax returns. Tax loss harvesting — deferring the recognition of capital gains and realizing capital losses in order to reduce taxes owed on capital gains — is widely accepted as one of the most successful active tax management strategies. However, implementing an effective loss-harvesting strategy can be challenging in practice. To deliver the best post-tax performance, you must carefully balance the loss-harvesting objective against your pre-tax investment goals. Managing this trade-off is made more complicated by the complexity and scale of tax-managed portfolio rebalancing and the high levels of customization required to accommodate each investor’s unique investment and tax circumstances.

With the right technology, the process can be made much easier. Using Qontigo’s direct indexing solutions, we compared post-tax returns of tax-agnostic and tax-managed investment strategies to decipher how beneficial active tax management can be. In our first analysis, we used a broad cap-weighted equity market index, followed by our second analysis where we tracked the STOXX Factor Indices to compare tax-agnostic strategies with tax-managed strategies. In both studies, we found that tax-managed strategies harvested significant capital losses while maintaining low tracking error to the indices.

Improved Post-Tax Portfolio Performance

In these studies, we used the Axioma Portfolio OptimizerTM (APO) to compare the post-tax returns of tax-agnostic and tax-managed investment strategies in simulations with historical market data and to make the most efficient trade-off between tax savings and tracking error. To measure the value of active management, we define tax alpha as the difference between the tax burden of a tax-managed strategy (the portion of annualized pre-tax return lost to taxes) and the tax burden of its tax-agnostic counterpart. A positive tax alpha means an increase in tax efficiency and higher tax savings. We also used the Axioma Factor Risk Models to estimate tracking error to the model portfolio and to capture risk premia.”

Figure 1: Potential Tax Alphas of Tax-Managed Strategies

Source: FTSE Russell, Qontigo.

The horizontal axis measures predicted tracking error to the reference tax-agnostic strategy. For smart-beta strategies, the tax-agnostic portfolios are the STOXX Factor Indices, which use the STOXX USA 900 as the investible universe. All return and tracking error values are annualized.

In our whitepaper “Generating Tax Alpha with Optimized Index Tracking”, the tax-agnostic strategies match the composition of the benchmark index at every rebalancing, whereas the tax-managed strategies harvest the maximum net capital losses while maintaining a specified tracking error to the index. Figure 1(a) presents the tax alphas that can be generated by the tax-managed strategies. All portfolios are rebalanced quarterly from March 1990 through June 2020.

Our second paper, “Tax Management for Smart-Beta Indices”, focuses on direct indexing strategies that maximize post-tax returns when using smart-beta indices. The tax-agnostic portfolios are the flagship  STOXX Factor Indices, which are designed to maximize exposure to target style factors and satisfy additional exposure, liquidity, and risk constraints. The tax-managed portfolios generate tax alpha while ensuring that the portfolio has a small tracking error to the tax-agnostic portfolio, maintains approximately the same factor exposure, and satisfies the same constraints as the tax-agnostic portfolio. Figure 1(b) details the tax alphas that can be achieved by the tax-managed strategies over the period from December 2001 through September 2020.

The Bottom Line

For both index-tracking and smart-beta strategies, the results indicate that active tax management can significantly increase post-tax returns while closely tracking the strategy’s investment mandate. Tax-aware portfolio construction provides a systematic approach for capturing this tax alpha and delivering higher post-tax returns.

Get a Deeper Dive

Check out the in-depth analysis tracking a broad cap-weighted equity market index here and STOXX Factor Indices here.