Index / ETFs — March 24, 2021

Tax Management for Smart-Beta Indices

In this paper, we analyze tax efficient smart-beta portfolios based on the flagship STOXX Factor Index Suite with direct indexing to realize the tax advantages. Smart-beta strategies naturally lend themselves to tax alpha given their high turnover. The STOXX Factor Index suite consists of the Value, Momentum, Small Size, Low Risk, and Quality single-factor indices and a multifactor index engineered to deliver the risk premium associated with each factor using a diversified index of securities with carefully managed exposure, liquidity, and risk characteristics.

We first document the poor post-tax performance of the tax-agnostic STOXX Factor Indices that are not designed with tax efficiency in mind. We then generate novel “tax-managed” factor portfolios by running a supplementary optimization that minimizes the tax gains of the portfolio while preserving the characteristics of the tax-agnostic portfolio, and show that they harvest an annualized tax-alpha ranging from 0.7-1.1% over the factor risk premium. We also show that our tax alpha results are robust by generating a hierarchy of tax-managed portfolios that trade-off factor alpha and tax efficiency, starting our backtests in different market environments, and running the tax optimization with different short-term and long-term tax rates.

Authors

Kartik Sivaramakrishnan, PhD

Director, Product Solutions

Zhe Liu, PhD

Research, Manager