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Abstract
This article examines the question facing taxable investors: How much of the equity portfolio should be invested in a tax-managed core portfolio versus active satellite managers? Historical simulations, which vary the level of active management skill, demonstrate the trade-offs between excess returns, turnover, and taxes. The authors’ results suggest that even in the presence of skilled active managers, the allocation to the core portfolio should exceed 50% for most investors. For taxable investors with moderate levels of aversion to risk, they find that the optimal allocation to the core portfolio should typically be greater than 50%, even if one expects satellite managers to deliver pretax excess returns of up to 4%. If investors are highly risk averse or expect lower levels of alpha from the satellite managers, then the optimal allocation is higher.
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