Index / ETFs — March 24, 2021

Tax Management for Smart-Beta Indices

Tax alpha is an often-overlooked source of improving passive and smart-beta index performance with direct indexing offering an approach to harvest tax alpha in practice. Once confined to high-net worth investors, direct indexing is open to a much lower threshold, allowing wealth managers to help their clients harvest losses and defer gains on individual securities in the portfolio while tracking a parent index and satisfying each client’s personal needs.

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 as smart beta strategies naturally lend themselves to tax alpha given their high turnover. We do this by:

  1. Documenting the relatively poor post-tax performance of the tax-agnostic STOXX Factor Indices that are not designed with tax efficiency in mind.
  2. Generating new “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.

The results show that:

  1. The “tax-managed” factor portfolios harvest an annualized tax-alpha ranging from 0.7-1.1% over the factor risk premium.
  2. Our tax alpha results are robust by generating a hierarchy of tax-managed portfolios that trade-off factor alpha and tax efficiency, starting our portfolio backtests in different market environments, and running the tax optimization with different short-term and long-term tax rates.

For more information about our direct indexing solutions, visit Qontigo Solutions for Direct Indexing.

Authors

Kartik Sivaramakrishnan, PhD

Director, Product Solutions

Zhe Liu, PhD

Research, Manager