What is a tax-aware strategy?
A tax-aware strategy can mean different things depending on who you ask. At AQR, we refer to an actively-managed systematic investing strategy that takes into account realized capital gains and losses during regular portfolio rebalances.
We view the tax costs of realized capital gains in much the same way as transaction costs. Asset managers routinely incorporate transaction costs into portfolio construction because investors care about returns net of transaction costs. Similarly, managers running strategies for taxable investors interested in returns net of tax costs should incorporate potential capital gain and loss realization in their portfolio construction process.
Why should taxable investors consider tax-aware strategies?
Alternative strategies may lose their attractiveness after taxes, which is one reason many taxable investors choose to avoid them. Managers of active strategies seek to achieve positive risk-adjusted returns (or alpha) through periodic rebalancing of their portfolios. Rebalancing without factoring in built-in gains often results in realizing such a large amount of capital gains that pretax returns might be completely offset by taxes on realized gains.
In other words, managers who disregard the tax consequences of their trading can generate very concrete and immediate tax costs in hopes of achieving much less certain future pretax returns. Tax-aware strategies, on the other hand, incorporate tax burdens of realizing gains and tax benefits of realizing losses directly into the portfolio construction process. We find that with systematic factor-based strategies, investors can achieve substantial tax savings with a relatively small impact on their pretax returns. 1 1 Close See Israel and Moskowitz (2012); Sialm and Sosner (2018); Dunn, Huupponen, Krasner, and Sosner (2018). As a result, tax awareness partially evens the playing field between taxable and tax-exempt investors in actively managed strategies.
Why is a systematic factor-based approach well suited for tax-aware strategies?
A few attributes of factor-based strategies, such as value, momentum, quality, or defensive, make them suitable for tax-aware investing. Consider, for example, factor-based stock-selection strategies. Such strategies use many stocks to represent just a handful of factors. This gives a manager the flexibility to use different positions to capture factor exposures while being mindful of the tax consequences of trading. In addition, factor-based strategies typically have holding periods that are long enough to allow a manager to defer capital gains from the short term to the long term but short enough to realize sizable short-term capital losses as a part of normal strategy portfolio rebalancing. Finally, systematic factor-based strategies naturally allow for shorting—a manager can go long relatively attractive stocks and short relatively unattractive stocks. From a tax perspective, a long-short approach to portfolio construction gives the manager the ability to realize capital losses on short positions in rising markets and on long positions in falling markets. 2 2 Close See Sialm and Sosner (2018) and Sosner, Krasner, and Pyne (2019).
How do tax-aware alternative strategies fit into an investor’s portfolio?
While circumstances might vary, one appropriate place for a tax-aware alternative strategy is within a larger allocation to alternative investments. Tax-agnostic alternatives often generate large short-term capital gains. We find that when tax-aware factor-based strategies are implemented in a long-short portfolio, short positions significantly enhance opportunities for realizing short-term capital losses. 3 3 Close See Sialm and Sosner (2018) and Sosner, Krasner, and Pyne (2019). These losses can offset short-term capital gains from less tax-efficient alternatives and thereby increase the tax efficiency of the overall allocation to alternatives. This is a key potential benefit, especially for investors who have been reluctant to consider alternatives due to their tax inefficiency.
Why is AQR uniquely qualified to manage tax-aware strategies?
Systematic factor-based long-short strategies are uniquely well suited for tax optimization, and AQR has always been at the frontier of factor-based investing. Our research on the subject is extensive and has been published in numerous industry and academic publications. Moreover, we’ve had decades of experience managing the risks and costs of long-short portfolios. As a result, our investment process already includes all the components necessary for tax-aware portfolio management—highly diversified portfolios, medium-term holding periods, ability to invest both long and short, a systematic approach to portfolio construction and rebalancing. So rather than creating an investment process around tax management, we merely incorporated tax awareness into the process that we have been running successfully for more than two decades.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.
Risks of Tax Aware Strategies
This list is not exhaustive; there are numerous advantages and risks associated with our Tax Aware Strategies that are not fully discussed here.
Underperformance of pretax returns: tax-aware strategies are investment strategies with the associated risk of pretax returns meaningfully underperforming expectations.
Adverse variation in tax benefits: deductible losses and expenses allocated by the strategy may be less than expected.
Lower marginal tax rates: the value of losses and expenses depends on an individual investor’s marginal tax rate, which may be lower than expected for reasons including low Adjusted Gross Income (AGI) due to unexpected losses and the Alternative Minimum Tax (AMT).
Inefficient use of allocated losses and expenses: the tax benefit of the strategy may be lower than expected if an investor cannot use the full value of losses and expenses allocated by the strategy to offset gains and income of the same character from other sources. This may occur for a variety of reasons including variation in gains and income realized by other investments, at-risk rules, limitation on excess business losses, or insufficient outside cost basis in the partnership.
Adverse changes in tax law or IRS challenge: the potential tax benefit of the strategy may be lessened or eliminated prospectively by changes in tax law or retrospectively by an IRS challenge under current law if conceded or upheld by a court. In the case of an IRS challenge, penalties may apply.