The Tax Benefits of Separating Alpha from Beta

doi:10.1080/0015198X.2019.1675421

Joseph Liberman
Clemens Sialm
Nathan Sosner
Lixin Wang

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.

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.

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