Figure 1. Hypothetical After-Tax Pre-Liquidation Information Ratio (IR) during a 10-Year Period Following the Transition
In a recent paper “Tax-Efficient Portfolio Transition: A Tax-Aware Relaxed-Constraint Approach to Switching Equity Managers,” we discuss portfolio transition techniques that could alleviate the tax costs of switching managers for a taxable investor.
Sosner, Nathan, and Stanley Krasner. 2021. “Tax-Efficient Portfolio Transition: A Tax-Aware Relaxed-Constraint Approach to Switching Equity Managers.” The Journal of Wealth Management 23 (4): 31-57.
We find that transition to a tax-aware “relaxed-constraint” strategy
A relaxed-constraint portfolio construction relaxes the long-only constraint by allowing the strategy portfolio to hold short positions whose value amounts to a fixed percentage of the portfolio’s net asset value (NAV). To keep the sum of portfolio weights equal 1.0, the long leg of the portfolio is levered up by the corresponding percent of the NAV. For example, a relaxed-constraint 130/30 strategy holds 130% of the NAV in long stock positions and 30% of the NAV is short stock positions.
yields a meaningful pre-tax alpha and high tax efficiency both during and after the transition. This allows an investor utilizing such an approach to achieve high after-tax post-liquidation returns.
We focus on transitioning an appreciated Russell 1000 benchmark portfolio to an actively managed strategy. 3 3 Close In the paper, we modeled hypothetical actively managed strategies as a value and momentum styles-based strategies. All the strategies we considered used identical hypothetical value-momentum signals. We model transition for a more and a less appreciated pre-transition portfolio, with a built-in gain amounting to 60% and 40% of the portfolio value, respectively, and track the pre-tax and after-tax performance for 10 years following the transition.
We assume that all the stock positions of an appreciated hypothetical portfolio are taken over by a new manager who implements either a tax-agnostic or a tax-aware transition to either a long-only (LO) or a relaxed-constraint (RC) style-premia-based actively managed hypothetical strategy. Post transition, the hypothetical strategies are managed consistently with transition—tax-agnostic transition is followed by tax-agnostic portfolio management and tax-aware transition is followed by tax-aware management.
Figure 1 below
Figure 1 presents the same data as Exhibit 7, Panel B, in the paper.
depicts after-tax information ratios
Information ratio is a standard performance statistic computed as the ratio of a strategy’s active return (its outperformance over benchmark) divided by its tracking error.
of the hypothetical strategies we considered in the paper. It shows that after taxes, both LO and RC hypothetical strategies implemented as tax-aware outperform their tax-agnostic counterparts. While not shown here, in the paper, we show that there is some pre-tax information ratio degradation due to tax awareness. However, as Figure 1 demonstrates, it is more than compensated by greater tax efficiency. Moreover, the hypothetical tax-aware RC strategy has a meaningfully higher after-tax information ratio than all the other strategies.
Further in the paper, we show that our main finding (that transition to a tax-aware RC strategy results in the best after-tax performance) is robust to liquidation taxes and to having pre-transition portfolios that are significantly more concentrated than a Russell 1000 benchmark portfolio.