Factor/Style Investing
How Tax Efficient Are Equity Styles?
July 1, 2011
Topics - Factor/Style Investing Equities
Chicago Booth Working Paper
Empirical asset pricing studies largely focus on the expected pre-tax real returns of asset classes and equity styles. For a taxable investor, however, the after-tax returns of assets are the critical input for investment decisions. We explore the after-tax performance, tax exposure and tax efficiency of commonly used (both in academia and practice) equity style portfolios. Specifically, we focus on equity styles based on size, value, growth and momentum, which dominate the cross-sectional return landscape.
First, we examine whether the relative after-tax performance of these styles is different than their pre-tax relative performance. Second, we decompose the capital gain, loss and income of each style to identify the drivers of its tax exposure. Finally, we analyze how much after-tax returns can be improved across styles through tax optimization and what the tradeoffs are between tax reduction and tracking error.
Our study focuses mostly on long-only investable “passive” indices from July 1974 to June 2010 (e.g., Russell 1000 and Russell 2000 core market, value and growth indices and AQR Capital Management’s U.S. large- and small-capitalization momentum indices). In addition, we also examine portfolios constructed from the Center for Research in Security Prices (CRSP) going back to 1927.
This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
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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The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons.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. Diversification does not eliminate the risk of experiencing investment losses.
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