Isolating Desirable Turnover via Separate Alpha and Beta Portfolios

Does separating the active (alpha) and passive (market exposure, or beta) components of an overall equity investment strategy, thereby isolating turnover, reduce overall tax burden? In their May 2018 paper entitled “The Tax Benefits of Separating Alpha from Beta”, Joseph Liberman, Clemens Sialm, Nathan Sosner and Lixin Wang investigate the tax implications of separating alpha from beta for equity investments. Specifically, they compare two quantitative investment strategies:

1. Conventional long-only – overweights (underweights) stocks with favorable (unfavorable) multi-factor exposures within a single portfolio.
2. Composite long-short – allocates separately to a passive (index fund) portfolio and to an active long-short portfolio targeting multi-factor exposures but with no exposure to the market.

They design these competing strategies so that aggregate exposures to the market and target factors, and thus pre-tax returns, are similar. They consider three target factors: value (60-month reversion) and momentum (from 12 months ago to one month ago), together and separately; and, short-term (1-month) reversal only separately. Their base simulation model has: 8% average annual market return with 15% volatility; 2% average incremental annual return for each target factor with 4% volatility; and, 180% annual turnover for value, momentum and value-momentum and 1200% annual turnover for short-term reversal. Their test methodology involves 100 iterations of: simulating a multifactor return distribution of 500 stocks; then, simulating portfolios of these stocks with monthly factor rebalancing for 25 years. They assume long-term (short-term) capital gain tax rate 20% (35%) and a highest-in, first-out disposition method for rebalancing. Based on the specified simulations, they find that: (more…)