Factor/Style Investing

How Tax Efficient Are Equity Styles?

Topics - Factor/Style Investing Equities

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How Tax Efficient Are Equity Styles?

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.

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 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. Diversification does not eliminate the risk of experiencing investment losses.

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.