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Long-only active investment strategies have an inherent flaw: Investors pay capital gains taxes on market-related gains as well as on the alpha created. By separating alpha and beta, taxes can be reduced and returns enhanced.


Overview

Long-only active investment strategies have an inherent flaw: Investors pay capital gains taxes on market-related gains as well as on the alpha created. By separating alpha and beta, taxes can be reduced and returns enhanced. Using both simulated and historical data, we show that separating active returns (i.e., alpha) from market exposure (i.e., beta) may have significant tax benefits. We find that an investment strategy that invests separately in a passive index portfolio and an actively managed long–short portfolio is more tax efficient than a long-only actively managed strategy with similar risk and style exposures. The turnover of a traditional active strategy causes capital gain realizations in both the active and passive portfolio components. In contrast, the turnover of a strategy that separates alpha from beta is concentrated in the long–short component and enables the deferral of capital gain realizations in the passive market component. Separating alpha from beta is different from systematic tax management as described in the literature. Our approach provides a practical solution for taxable investors in a world dominated by tax-agnostic managers.

About the Author(s)

Joseph Liberman

Joseph Liberman is an associate at AQR Capital Management, Greenwich, Connecticut.

Clemens Sialm

Clemens Sialm is a professor of finance at the University of Texas at Austin, a research associate at the National Bureau of Economic Research in Cambridge, Massachusetts, and an independent contractor at AQR Capital Management, Greenwich, Connecticut.

Nathan Sosner

Nathan Sosner is a principal at AQR Capital Management, Greenwich, Connecticut.

Lixin Wang

Lixin Wang is a vice president at AQR Capital Management, Greenwich, Connecticut.