It’s no secret that members of the Trump Administration have had their hands on the tax code. It of course started with landmark legislation passed towards the end of 2017 and most recently Treasury floating the idea of indexing capital gains taxes to inflation. Capital gains taxes are currently agnostic towards inflation rates, and so the long-term compounding of said gain will ultimately be taxed at its basis cost, rather than at an inflation-adjusted basis. That rubs some former investors in the administration the wrong way.
This is prototypical thinking from market participants because we viscerally understand that capital gains taxes present perverse incentives to price equilibrium. Economists, sociologists, and academics understand that taxation is not only concerned with the transactional equilibrium but also with societal distribution effects. We’re also not here to opine on the opportunity for arbitrage presented by most tax reform. Speaking from our asset manager purview, the boogieman of taxable capital gains is an all-too familiar meme with taxable investors, several of which are almost forced to optimize to tax above all else when considering investment opportunities.
A Brief Walk Down Academia
Without veering into a tedious history of academic research, two foundational works by Diamond and Mirrlees (1971) and Atkinson and Stiglitz (1976) expand on the seminal works by Ramsey (1927) regarding optimal taxation. This canon of works introduce the ideal of optimality through the lens of distributional consideration, equitability, and efficiency. They quantify (through idealistic assumptions) various forms of taxes from direct, indirect, excise and progressive formats. Fast-forwarding to the topic at hand, much of the literature points to an optimal tax on capital as being zero. We of course live with the reality of capital gains taxes in the United States. We have a progressive taxation that is delineated by duration (short-term, long-term) and state/local rules (certain jurisdictions treat said gains unequally). This system provides distributive gain as it pertains to taxing capital which accumulates in a non-normative fashion (as does wealth in this country) but leads to undesirable externalities surrounding efficiency and avoidance. Even with this theoretically sub-optimal system, recent researchers such as Piketty (2013) point to increasing distributional problems of capital compounding outstripping growth, as well as the thorny issue of tax avoidance.
Asymmetries: Passive v Active
We are not here to delve into the political or distributive. We’ll talk more micro regarding the impact of capital gains taxes on taxable asset allocators and their decision-making frameworks. Central to this post is the asymmetry of capital gains tax between passive and active. There is a huge tax advantage with passive investing. The vast majority of passive investments are market-capitalization weighted, which reduced the taxable drag associated with rebalancing vs any other weighting schema (e.g., equal-weighted). The most popular product for delivering passive investments (ETFs) is structurally tax efficient, through creation units which avoid having inflows/outflows cause distributive taxable events. Finally, fueled by a vague IRS code, tax-loss harvesting is made relatively facile with passive instruments.
Asymmetries: Long v Short Alpha
To take it a step further, within the structurally less tax-efficient realm of active management, there is an asymmetry between the treatment of tax on the generation of alpha. While not immutable mathematically (we haven’t thought about it hard enough), it is overwhelmingly the case that alpha is taxed more heavily on the long side as compared to the short side. This is because a baseline beta return for most asset classes on the short side is a tax-loss harvest versus a capital gain on the long! If we believe that long-term asset class returns are positive compared to the risk-free rate, then shorting said instruments will yield taxable losses. By extension, any alpha that is capital-losing (i.e., outperforms its relative benchmark but does not create absolute gain) also enjoys the benefit of positive tax impact.
As an example, take a conservative manager who runs their portfolio 75% long and sits on 25% cash. This manager is a deep-value gal who is patient in deploying capital. Let’s assume that she creates a ~2% annualized alpha term versus her domestic equity benchmark ( S&P 500 TR), and the portfolio manages basis risk to the index relatively well. This alpha term is calculated on an IRR basis and does not include the cash in the portfolio (i.e., her long book at 75% exposure outperforms a .75x return stream of SPY on an annualized basis by 2%). As is the case with most active managers, let’s assume that her turnover is 40% annualized and that the taxable split varies but is predominantly long-term capital gain. Here’s a look at the portfolio’s return stream over a decade+ back-test versus an exposure-adjusted return stream of the S&P 500:
Now let’s compare this portfolio’s post-tax attractiveness to the same long book which is constructed 100% long (same portfolio just fully allocated, pro rata), and a 25% short in S&P 500 ETFs, rebalanced quarterly, undulating between comparable ETFs to harvest tax losses at the quarterly trade. Doing so is important because in a rising market, a short exposure to the market is generating unrealized losses. One can crystalize those loses and create a tax loss harvest. Mind you, the exposure in Portfolio #2 is synthetically the same as the original portfolio (75% net). Let’s superimpose Portfolio #2’s pre/post tax on top of Portfolio #1:
The pre tax return changes by ~3% cumulative over 14 years, which is negligible. The post-tax return however increases by ~13% (145.76% – 133.15%), or 1/10th of cumulative gain. This highlights how negative tax paid to beta is crucial to optimizing returns. Because the impact of paying capital gains from the beta component of your return can be neutralized with a short portfolio (which can harvest tax-losses while achieving beta-neutralization), it is to be expected that post-tax gains are enhanced via long/short portfolios with comparable net exposure. This is a startling inequality and one that doesn’t even demonstrate the further advantage of capturing alpha from the short-side in addition to hedging.
To provide some corollary research, you can read this influential by Berkin which demonstrates the improvement of after tax return (of up to 50bps annualized) through simple extension (running a portfolio 130% long with a matching 30%, rather than long-only). This is without any specific tax loss harvesting on the extension side, which is even more superior (Extended Tax). Here’s a summary table of their findings which mirrors ours:
Ultimately, taxable investors need to think about their asset allocation not only through the spectrum of alpha and beta, or long and short, but also how tax interacts asymmetrically with both.
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