A Proposal for Tax-Efficient Active Equity Investing

Abstract

The author argues that the typical active equity investor hopes to garner return from two sources: market exposure and manager alpha. In a traditional long-only portfolio, the two are inextricably tied together, yet the inevitable active turnover leads to tax inefficiency. Capturing the market risk premium, on the other hand, requires almost no turnover. Consequently, separating these two sources of return could maximize tax efficiency while retaining the potential to generate a return through active management. The author then proposes a structure that can be applied to an overall portfolio, or to any allocation to a specific asset class. Any actively managed long-only portfolio can be thought of as a combination of an index portfolio and a market neutral long-short portfolio. Splitting a long-only portfolio into these two components can dramatically increase tax efficiency (by leaving the index portfolio completely undisturbed) and also maintain a high level of portfolio management flexibility (by avoiding much of the ‘lockup’ problem). The market neutral strategy can provide both alpha capture and tax efficiency, if implemented with an eye toward harvesting capital losses to offset realized capital gains.