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2 December 2019 Financial Analysts Journal

The Tax Benefits of Separating Alpha from Beta (Summary)

  1. Phil Davis

This summary gives a practitioner’s perspective on the article “The Tax Benefits of Separating Alpha from Beta,” by Joseph Liberman, Clemens Sialm, Nathan Sosner, and Lixin Wang, published in the Financial Analysts Journal in the 1Q issue of 2020.

Listen to an audio version of this summary.

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.

What’s the Investment Issue?

Some investors are wary of traditional long-only active strategies because of the tax burden they generate, particularly if the fund manager is tax agnostic. Capital gains taxes can meaningfully reduce the average alpha of a successful long-only strategy.

The authors argue that by separating active (alpha) and passive (beta) exposures, investors can benefit from greater tax efficiency relative to a long-only active fund. The passive (beta) component requires fewer trades than an active long-only fund, so capital gains taxes on the passive component can be deferred while incurring capital gains tax costs only on the actively managed component. A long-only strategy, however, generates taxes on both the passive market return and the active excess return.

How Do the Authors Tackle the Issue?

The authors compare the after-tax returns of long-only value and momentum strategies with those of an alternative approach that separates alpha and beta while keeping the exposures as close as possible to the long-only strategy. The alpha component is implemented through a market-neutral long–short portfolio, and the beta component, via a separate passively managed portfolio requiring minimal turnover.

The authors use simulation in order to compare tax efficiency under various return distribution parameters. They also compare their findings from simulated returns with performance based on real historical data from 1995 to 2018.

What Are the Findings?

The composite approach—separating alpha from beta—materially outperforms a traditional long-only strategy after taxes. In the simulated environment, separating alpha and beta produces an average of 1.3% more after-tax alpha than traditional long-only strategies. The after-tax benefits of separating alpha increase with rising market returns, factor premiums, and portfolio turnover.

The results are confirmed by the historical data. Although the active risks, turnover, and active leverage are almost identical, separating alpha and beta reduces the tax costs and improves the after-tax, after-cost alpha relative to the long-only portfolio. The benefit relative to long-only management is correlated with overall market returns and increases when turnover rises.

What Are the Implications for Investors and Investment Managers?

Separating alpha from beta represents a new approach to tax efficiency compared with existing methods, such as tax-managed and relaxed-constraint funds or strategies that are tax-managed through separate accounts. The composite approach can provide a simpler and more practical solution for taxable investors in a world dominated by tax-agnostic fund managers.

The approach is particularly beneficial for investors who are considering replacing their active manager: Replacing the active (alpha) component without changing the passive (beta) component produces significant tax benefits, particularly when the active portion has underperformed and created a capital loss.

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