Active Style Diversification in an After-Tax Context

Abstract

The author asks whether style diversification retains its arguable pretax benefits when considering taxes. First, he reviews the two generic arguments – market timing and manger focus - offered to support the suggestion that style diversification actually produces value added on a pretax basis. Then, he presents and discusses the results of two experiments designed to evaluate the extent to which style timing and manager focus can add value on a pretax basis, in various circumstances. Finally, the author repeats these same experiments on an after-tax basis to review the impact of either approach on an after tax basis. He concludes that diversification benefits do not seem to persist when taxes are taken into account, and that a more successful strategy might be to take as a broad portfolio focus as possible, in order to capture the tax-efficiency benefits likely to arise across asset classes or sub-categories.