Managing One of the Greatest Costs Investors Face: Taxes
Gerstein Fisher’s Tax-Managed Equity Strategy Overview
By Gregg S. Fisher and the Research and Investment Team of Gerstein Fisher*
While investors are well-served by considering “low-cost” investment strategies, controlling a portfolio’s cost structure by focusing solely on management fees and expense ratios overlooks a significant drag on net returns: taxes. In fact, in many cases the difference between a pre- and post-tax investment return may be much greater than the costs associated with that investment’s management fees. Research has shown that investors in even relatively simple, low-turnover options such as index-tracking mutual funds unwittingly forgo more than 1% of their annual take-home returns due to taxes1,2. Between income taxes on interest, dividends, and capital gains paid on fund distributions or sales of individual securities, almost any portfolio can carry a significant ongoing tax burden, and more actively-managed strategies (which typically hold fewer positions and trade more frequently) tend to be even costlier.
To the extent that they do pay attention to taxes, many advisors use portfolio turnover as a proxy for tax efficiency. This is a simplistic view which ignores the fact that there is “bad” turnover and “good” turnover. From a tax perspective, bad turnover occurs when selling positions that trigger capital gain taxes, especially at the higher short-term rate. Good turnover either defers gains to the lower long-term rate or realizes capital losses. As we manage investors’ assets, our ongoing role is to carefully balance the expectations of risk and return of a portfolio (and every security within the portfolio) with the after-tax cost or benefit of each trade. In fact, by integrating tax management into an investment strategy, it is possible not only to lessen an investor’s tax burden, but also to create the potential for “tax alpha,” or additional returns generated through active tax management when compared to a non-tax-managed alternative.
This paper explores Gerstein Fisher’s Tax-Managed Equity Strategies in terms of the two core ways in which these strategies are applied: an indexing approach and a Multi-Factor® approach in which we apply both tax management and quantitative risk-factor analysis to target better risk-adjusted and after-tax returns for our investors.
1 Fisher & Maymin, “Past Performance is Indicative of Future Beliefs,” Risk and Decision Analysis 2 (2010/2011).
2 For the purposes of this paper, we have estimated tax rates and after-tax costs/benefits based on four tax rates: 40% for ordinary dividends, 40% for short-term realized capital gains, 25% for qualified dividends, and 20% for long-term capital gains. Note that these rates approximate the effective marginal tax rates for a typical investor in a Gerstein Fisher tax-managed equity strategy.