The Tax Benefits of Separating Alpha from Beta

Figures & data

Figure 1. Relationship between Performance of Long-Only and Composite Long–Short Strategies

Table 1. Distribution of Pretax and After-Tax Returns and Alphas across Simulations

	Returns				Alphas
	Long-Only	Composite Long–Short	Difference		Long-Only	Composite Long–Short	Difference
Pretax
Mean	9.5%	9.7%	0.2%		2.0%	2.2%	0.2%
Std. dev.	2.9	2.9	0.3		0.5	0.5	0.3
Minimum	1.3	1.2	–0.4		1.0	1.0	–0.4
Median	9.8	10.0	0.2		2.0	2.3	0.2
Maximum	16.6	17.1	0.9		3.2	3.3	0.9
Proportion positive	100.0	100.0	77.0		100.0	100.0	75.0
Taxes
Mean	–1.4%	–0.2%	1.1%		–1.4%	–0.2%	1.1%
Std. dev.	0.5	0.1	0.5		0.5	0.1	0.5
Minimum	–2.6	–0.5	–0.1		–2.6	–0.5	–0.1
Median	–1.5	–0.2	1.2		–1.5	–0.2	1.2
Maximum	–0.3	0.0	2.4		–0.3	0.0	2.4
Proportion positive	0.0	0.0	99.0		0.0	0.0	99.0
After tax
Mean	8.1%	9.4%	1.3%		0.6%	1.9%	1.3%
Std. dev.	2.4	2.9	0.6		0.7	0.4	0.6
Minimum	0.9	1.0	0.1		–1.2	0.8	0.1
Median	8.4	9.8	1.3		0.6	2.0	1.3
Maximum	14.0	17.0	3.0		2.1	2.9	2.9
Proportion positive	100.0	100.0	100.0		84.0	100.0	100.0

Figure 2. Relationship between Pretax Returns and Tax Costs

Figure 3. Relationship between Turnover and Alpha

Table 2. Performance at Various Turnover Levels

	90% Turnover			180% Turnover			360% Turnover
	LO	CLS		LO	CLS		LO	CLS
Active return
Pretax	1.5%	1.7%		2.0%	2.2%		2.3%	2.3%
Taxes	– 1.1	– 0.2		– 1.4	– 0.2		– 1.7	– 0.3
After tax	0.4	1.5		0.6	1.9		0.5	2.1
Active risk
Pretax	2.0%	2.3%		2.4%	2.3%		2.6%	2.3%
After tax	2.0	2.3		2.4	2.3		2.7	2.3
Information ratio
Pretax	0.74	0.73		0.83	0.94		0.87	1.00
After tax	0.18	0.65		0.25	0.84		0.21	0.90

Table 3. Taxes at Different Average Market Return Levels

Average Market Return	90% Turnover			180% Turnover			360% Turnover
	LO	CLS		LO	CLS		LO	CLS
0%	–0.2%	–0.2%		–0.3%	–0.3%		–0.4%	–0.3%
4%	–0.6	–0.2		–0.8	–0.3		–1.0	–0.3
8%	–1.1	–0.2		–1.4	–0.2		–1.7	–0.3
12%	–1.7	–0.2		–2.0	–0.2		–2.5	–0.2

Table 4. Performance at Various Factor Return Levels

	Factor Return = –2%			Factor Return = 0%			Factor Return = 2%
Metric	LO	CLS		LO	CLS		LO	CLS
Active return
Pretax	–2.0%	–2.1%		0.0%	0.0%		2.0%	2.2%
Taxes	–0.8	0.0		–1.1	0.0		–1.4	–0.2
After tax	–2.7	–2.1		–1.1	0.0		0.6	1.9
Active risk
Pretax	2.3%	2.2%		2.4%	2.3%		2.4%	2.3%
After tax	2.3	2.2		2.4	2.3		2.4	2.3
Information ratio
Pretax	– 0.85	– 0.96		– 0.01	0.00		0.83	0.94
After tax	– 1.16	– 0.96		– 0.45	0.00		0.25	0.84
Turnover	180%	180%		180%	180%		180%	180%

Table 5. Tax Benefits in Different Tax Rate Scenarios

Tax Assumption	LO	CLS
Base-case tax rates (short-term = 35%, long-term = 23.8%)	–1.4%	–0.2%
2019 tax rates (short-term = 40.8%, long-term = 23.8%)	–1.6%	–0.3%
Uniform tax rate (short-term = 20%, long-term = 20%)	–1.3%	–0.2%
Offset of capital gains of the same category	–1.0%	0.3%
Open-end mutual fund	–1.4%	–0.9%

Table 6. Tax Consequences of Manager Termination at Various Horizons

Investment Horizon (years)		Factor Return = –2%			Factor Return = 0%			Factor Return = 2%
		LO	CLS		LO	CLS		LO	CLS
5		–0.5%	3.7%		–1.7%	0.9%		–2.6%	–1.6%
10		–1.1	4.6		–2.3	0.5		–3.2	–2.5
20		–0.5	4.8		–2.0	–0.3		–3.0	–2.7
25		–0.7	4.5		–2.3	–0.3		–3.3	–2.5

Figure 4. Average Simulated Cumulative Portfolio Values with Liquidation

Table 7. Performance Net of Fees, Trading Costs, and Financing Costs

	90% Turnover			180% Turnover			360% Turnover
Metric	LO	CLS		LO	CLS		LO	CLS
Active return
Pretax, gross	1.5%	1.7%		2.0%	2.2%		2.3%	2.3%
Transaction costs	–0.2	–0.2		–0.4	–0.4		–0.7	–0.7
Financing costs	0.0	–0.5		0.0	–0.5		0.0	–0.5
Fees	–0.6	–0.7		–0.6	–0.8		–0.6	–0.7
Pretax, net	0.8	0.3		1.1	0.6		1.0	0.4
Taxes	–1.1%	–0.2%		–1.4%	–0.2%		–1.7%	–0.3%
After tax, net	–0.4	0.1		–0.3	0.3		–0.7	0.1
Active risk
Pretax	2.0%	2.3%		2.4%	2.3%		2.6%	2.3%
After tax	2.0	2.3		2.4	2.3		2.7	2.3
Information ratio
Pretax, net	0.38	0.13		0.45	0.24		0.38	0.17
After tax, net	– 0.18	0.04		– 0.12	0.14		– 0.27	0.05

Table 8. Performance of Tax-Agnostic and Tax-Aware Strategies in Historical Simulations, 1985–2018

	Tax-Agnostic Strategy			Tax-Aware Strategy
Metric	LO	CLS		LO	CLS
Active return
Pretax, gross	1.3%	2.0%		1.2%	1.9%
Transaction costs	–0.4	–0.4		–0.3	–0.4
Cost of leverage	0.0	–0.5		0.0	–0.5
Fees	–0.6	–0.7		–0.6	–0.7
Pretax, net	0.4	0.4		0.3	0.4
Taxes	–1.5%	–0.3%		–0.8%	0.0%
After tax, net of costs	–1.1	0.2		–0.5	0.3
Active risk
Pretax	2.1%	2.3%		2.1%	2.3%
After tax	2.1	2.3		2.1	2.3
Information ratio
Pretax, net	0.18	0.19		0.14	0.16
After tax, net	–0.53	0.07		–0.23	0.15
Realization of gains and losses in excess of benchmark
Long-term capital gains (losses)	4.7%	3.0%		5.3%	3.5%
Short-term capital gains (losses)	0.9	–2.2		–1.9	–5.5
All capital gains (losses)	5.6	0.8		3.4	–2.0
Portfolio characteristics
Annual turnover, % of NAV	180%	182%		169%	182%
Gross notional value, % of NAV	100	195		100	195
Active leverage, % of NAV	97	95		95	95

Table 9. Tax Benefits in Various Tax Scenarios in Historical Simulations, 1985–2018

Metric	LO	CLS
Active return
Pretax, gross	1.3%	2.0%
Transaction costs	–0.4	–0.4
Cost of leverage	0.0	–0.5
Fees	–0.6	–0.7
Pretax, net	0.4	0.4
Taxes in various tax scenarios
Base-case tax rates (short-term = 35%, long-term = 23.8%)	–1.5%	–0.3%
2019 tax rates (short-term = 40.8%, long-term = 23.8%)	–1.7	–0.3
Uniform tax rate (short-term = 20%, long-term = 20%)	–1.2	–0.3
Offset capital gains of the same category	–1.3	0.3
Open-end mutual fund	–1.5	–0.7
After-tax net return in different tax scenarios
Base-case tax rates (short-term = 35%, long-term = 23.8%)	–1.1%	0.2%
2019 tax rates (short-term = 40.8%, long-term = 23.8%)	–1.3	0.1
Uniform tax rate (short-term = 20%, long-term = 20%)	–0.8	0.2
Offset capital gains of the same category	–0.9	0.7
Open-end mutual fund	–1.1	–0.3

Figure 5. Relationship between Market Return and Tax Savings for the CLS Strategy Compared with the LO Strategy in Historical Data Simulations, 1985– 2018

Figure 6. Relationship between Annual Turnover and Tax Savings for the CLS Strategy Compared with the LO Strategy in Historical Data Simulations, 1985–2018