Tax-Adjusted Portfolio Optimization and Asset Location: Extensions and Synthesis

Abstract

Models developed in a pretax framework do not necessarily apply in an after-tax framework, and this notion certainly applies to portfolio optimization. This article derives generalized tax adjustments to return and volatility inputs in an after-tax portfolio optimization algorithm. It extends the literature by incorporating an asset’s cost basis, addressing a broader array of taxable entities, and deriving expressions for off-diagonal terms in the covariance matrix. They develop a comprehensive framework that distinguishes between tax-adjustments predicated on pretax market values and after-tax values. The distinction is important so that portfolio managers can avoid inadvertently blending two inconsistent approaches.

TOPICS: Portfolio construction, legal/regulatory/public policy, performance measurement