The question of whether taxes erode the gains from active management was first posed by Robert Jeffrey and Robert Arnott in 1993. For example, a value strategy’s success depends on buying stocks with low valuations and generating alpha by selling them as they appreciate. For taxable investors, the capital gains create a tax liability that reduces their alpha.

While active management often relies on high turnover, the financial literature has focused on tax-exempt investing. Taxable investors are largely unaware of portfolio tax issues, and managers typically strive to maximize pretax returns. Studies of after-tax performance typically rely on assumptions that can render the results irrelevant for many investors. The authors of this study examine scenarios where tax management—the practice of disciplined loss harvesting within a defined investment objective—may result in a tax alpha that can be realized by investors.

The authors compare the after-tax active returns of a tax-managed index-tracking portfolio and six factor-tilted portfolios with those of corresponding strategies managed without consideration for taxes (“tax-indifferent” strategies). Four factor-tilted portfolios—Value, Value Momentum, Small Value, and Multi Factor—have a targeted forecast beta of one (“beta-1” strategies) and two strategies, Quality and Minimum Volatility plus Value, have below-market target betas (“lower-risk” strategies). The Russell 1000 Index is the universe and benchmark for all portfolios except the Small Value portfolio, which uses the Russell 3000 Index. The benchmarks are taxed as exchange-traded funds (ETFs) that make no capital gains distributions.

Tax management is generally implemented by loss harvesting, or immediately taking losses while delaying gains. When the ratio of short-term to long-term tax rates is high, the tax rate differential can be managed by taking long-term gains in order to facilitate the harvesting of short-term losses.

The authors compute returns for 52 rolling quarterly 10-year periods using the highest federal tax rates and zero state taxes. All portfolios are assumed to be estate/donation portfolios that are passed on tax-free at the end of the investment horizon. Returns are calculated at monthly portfolio rebalancing intervals. The after-tax active return comprises the factor alpha, the tax alpha, and a pre-tax residual, which is the pre-tax difference between the tax-managed and tax-indifferent counterparts.

The authors vary their analysis by calculating returns using lower federal tax rates, a high state tax, and a portfolio liquidation scenario. They then calculate factor tilt “hurdle rates,” or how much additional alpha factor-tilted portfolios must generate to compensate investors for not investing in an indexed portfolio. Finally, they examine the impact of tax management during regimes of declining index returns.

All strategies demonstrate value added by tax management at the 10-year horizon. Incremental after-tax active return range from 1.50% per year for Quality to 2.16% for the index strategy, which consistently had the highest average tax alpha. The beta-1 strategies have significantly higher tax alphas than the lower-risk strategies. Each beta-1 strategy captures at least 70% of the tax alpha of the indexing strategy, compared with less than 35% for the lower-risk strategies. The lower-risk strategies have fewer securities and roughly two-thirds the volatility of the beta-1 strategies, which contributes to reduced opportunities for loss harvesting.

The authors observe that lowering the capital gains tax rates significantly reduces the tax alpha for the index strategy and the beta-1 factor-tilted strategies while diminishing the Quality tax alpha and erasing the tax alpha for Minimum Volatility plus Value. Introducing a high state tax rate increases the tax alpha for the index tracking strategy and the four beta-1 factor-tilted strategies; the tax alphas for the lower-risk strategies are minimally affected.

The liquidation scenario reflects active returns after tax liabilities have been paid. Liquidation portfolio tax alphas are lower for all strategies except the lower-risk strategies. These portfolios have slightly higher tax alphas because they have fewer capital gains—hence, lower tax liabilities—versus their benchmarks. Lastly, the regime-change analysis shows that, consistent with the previous literature, tax alpha tends to improve as index performance declines.

One notable finding highlighted by the authors is that tax alphas for the factor-tilted portfolios are largely the result of managing the tax rate differential and so depend heavily on having an abundance of short-term gains to offset.

Tax alphas are highly dependent on investor-specific factors. High federal and state tax rates increase tax alpha relative to lower tax rates. Strategy choice, too, impacts tax management benefits; investors may want to consider the hurdle rates when choosing a factor strategy. Indexed strategies yield the highest tax alpha, whereas lower-risk strategies tend to have the lowest tax alphas. And because compounding contributes to alpha over the long term, tax alphas tend to be lower for longer horizons.