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Investment professionals often promote their ability to generate excess investment returns—referred to as Alpha—through superior stock-picking skills and proprietary investment strategies.
However, academic research dating (all the way!) back to the 1960s reveals that achieving consistent Alpha through these methods is extremely rare and unreliable (Jensen (1968)). Moreover, the quest to generate Alpha in this way often results in negative Alpha due to higher taxes, transaction costs, and research expenses (Sharpe (1991); Hsu, Litterman and Zeckhauser (2004)).
However, Tax Alpha is reliable, repeatable and accessible to all investors. In this article, we will review 2 simple strategies to reduce the tax drag on your investments and generate your own Tax Alpha. And for Corporate Executives, these strategies are especially valuable due to your high tax rates and access to unique tax-advantaged account types.
But regardless of which Greek letter we're using, the key point is that by minimizing your taxes, investing those savings and letting those returns compound over several years you can significantly increase the probability of achieving your financial goals.
Generate Tax Credits from Strategically Swapping Positions at a Loss
Tax Loss Harvesting (TLH) is realizing losses by selling shares that have fallen below the original cost basis to generate tax credits.
Chaudhuri, Burnham and Lo (2020) find that TLH provided a geometric average of 1.08% in tax alpha per year using U.S. historical data from 1926 - 2018.
However, the authors find that the benefits of TLH are highly variable (albeit positive) over the period. This variability is a function of market volatility, return dispersion of individual securities, and an individual's tax rate.
For instance, the 1926 - 1949 period offered an ideal environment for generating tax credits through TLH, marked by a volatile stock market with high dispersion amongst individual securities and low returns, followed by a recovery period with high returns benefitting from the harvesting of earlier losses. In contrast, the economic expansion and low volatility of the 1949 - 1972 period resulted in less opportunity for TLH Alpha, though it remained positive.
Beyond market conditions, certain types of investors benefit more from TLH than others. First, wealth accumulators—investors who consistently contribute savings to their portfolios—benefit from purchasing higher-cost-basis tax lots over time. Second (and more intuitively), investors in high tax brackets have more to gain through tax efficient strategies including Tax Loss Harvesting.
High earning corporate executives, who are typically accumulating wealth and exposed to high tax brackets, can particularly benefit from TLH compared to the average investor.
Minimize Taxes by Placing Highly Taxed Investments in Tax-Advantaged Accounts
Asset Location (not to be confused with Asset Allocation) generates Tax Alpha by placing relatively higher taxed investments - such as Taxable Bonds - in tax advantaged accounts such as an IRA, 401k or Deferred Compensation Plan. This is counter to the traditional financial planning approach in which the interaction between taxable and tax-deferred accounts is largely ignored.
Dammon, Spatt and Zhang (2004) in their paper, "Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing" find "a strong locational preference for holding taxable bonds in the tax-deferred account and equity in the taxable account".
Reichenstein and Meyer (2013) in their article, "The Asset Location Revisited" find that the account type impacts an investments risk and return. Tax-deferred accounts carry an embedded tax liability, meaning the government shares in the return and risk of the investment. As a result, pre-tax expected risk and return should be adjusted by (1 - Tax Rate) to reflect this limited partnership-like arrangement. In other words, asset allocations need to be viewed post-tax to reflect the investor's portion of risk and return.
There are exceptions to the general advice of concentrating taxable bonds in tax-deferred accounts. Daryanani and Cordaro (2005), in "Asset Location: A Generic Framework for Maximizing After-Tax Wealth," note that the optimal location may depend on a client’s financial profile (e.g., cash flow and tax situation), prevailing tax laws, and the tax characteristics of the asset classes in the portfolio.
The takeaway is that by strategically placing highly taxed investments in tax-advantaged accounts, investors can boost after-tax investment returns. Corporate executives, in particular, have a unique opportunity to benefit from asset location strategies, as they often have access to multiple tax-deferred accounts, including 401(k)s and Non-Qualified Deferred Compensation Plans.
Tax Alpha is Repeatable and Scalable Over Several Years
In most cases, the success of reaching your financial goals is dependent on the outcomes of several small decisions (albeit getting the big decisions right such as retirement are crucial.)
Although a low-single-digit improvement from Tax Alpha in a single year may seem inconsequential to your future, an incremental return of approximately 1 -2% over time can significantly enhance your ability to reach your financial goals faster and with more confidence—especially since this return can be achieved without necessarily increasing the risk or uncertainty in the portfolio.
Thanks for reading,
Mark Chisenhall, CFA, MBA
Financial Advisor | Founder of Taurus Financial Planning
Taurus Financial Planning is a Fee-Only Wealth Management firm based in Bentonville, AR. The firm offers comprehensive financial planning, tax planning and investment management to corporate executives across the country.
Taurus Financial Planning is a Registered Investment Advisor with the State of Arkansas. This information is provided as a guide to assist you in your financial planning. The specific examples are provided for illustration purposes only and are not representative of specific investments or guarantees of future returns. Please consult with a professional for specific questions regarding your particular situation. If there is any error or inconsistency between this document and the official company plan documents, your company plan documents will govern.
This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.
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