Alpha is elusive. Some advisors claim they’ve achieved it, only to have it slip through their fingers. Many of the most prestigious investment firms have spent billions developing algorithms trying to track it down. When alpha appears, it comes down to fractions of a second, and pennies per share, and the hope that high enough volume can overcome the steep price paid for the slender advantage. However, whether guru or algorithm, the costs often eat up any supposed alpha that may exist.
What is alpha?
Alpha is the return on stocks or bonds due to the skill of the fund manager. It is distinct from beta, which measures the gains in a fund that is caused by the overall market. Alpha is meant to inform an investor of how much additional benefit they received, above the market rate of return, from being in the selected fund. It’s the value that the manager brings to the table.
However, few managers actually deliver expense-adjusted alpha, and even fewer can do so on a consistent basis. According to Dimensional Fund Advisors, the average alpha of mutual funds in existence between January 1991 to June 2020 is negative, and if you put back the funds that didn’t survive that time the alpha drops even further. Any way you slice it, active mutual fund managers, on average, don’t outperform the benchmark. They simply don’t (or perhaps can’t) bring alpha.
Tax Adjustments for Alpha
Does that mean that an investor should throw in the towel and accept that alpha is some mythical creature reserved for the dreams of children? No! While traditional alpha remains a fool’s errand, we can create alpha on a tax-adjusted basis. Imagine a scenario in which an investor can use the tax code to his or her advantage, create capital losses, and then use those capital losses to offset gains on another asset, or perhaps capital gain distributions form mutual funds.
If you will it, it is no dream. Such scenarios exist, and they are largely known as active tax loss (ATL) harvesting. Members of the WRP team have written about ATL in trade publications since 2013. Furthermore, there are a number of companies that purport to offer ATL, and the number of investment firms continues to expand as demand rises.
Tax loss harvesting has been going on for decades. Traditionally, stockholders wait until the end of December, take stock as to what securities are in loss positions, and then trade out to cover their gains on the year. While this blunt instrument is extremely useful, it can be carried out more efficiently. The premise of ATL is to sell stocks at a loss as they occur, instead of waiting until year end.
Moreover, ATL lets investors use passive indexing to maximize potential gains, and some even apply screens to tilt portfolios to value, small, and profitability. So, not all ATL is built equal, but the underlying premise is the same: buy a representative portion of an index such that you minimize the tracking error, as the year goes on sell the losers, then purchase a different security in its place that will keep the portfolio relatively in-line with the index.
Active Tax Loss Harvesting in Action
The classic example of this technique is a portfolio that contains $100 worth of Coca-Cola (KO). Let’s say for some reason KO fell 10% because of a bad earnings report. An ATL would sell that stock and pick up a different stock in its place that is somewhat similar, like Pepsi (PEP). Is Pepsi a perfect match? No. The companies are massive conglomerates and have different exposures. But as long as Pepsi keeps the portfolio close to the index, that’s what matters.
Investors who engage in ATL are certainly rewarded for their efforts, even on a cost-adjusted basis. Obviously, the higher the income tax bracket, the more valuable the capital loss is. When it comes to long-term capital gains, in California, the top brackets pay 13.3% for state, 23.8% for Federal. Short-term capital gains are the same for California, but the Federal rate tops out at 40.8%. Companies like Parametric have been doing ATL for 25 years and can show that benefit in real dollars.
According to data provided by Parametric, for the period starting in 2010 and ending in 2019, a portfolio that started with $1 million that was purely in the S&P 500 would have risen to $3.28 million. If an investor would have overlaid an ATL strategy and had long-term capital gains, they would have been able to capture $240,000 of additional after-tax benefit. (Note: because Parametric is a national company, it doesn’t include state tax data, so a Californian would actually receive a bigger benefit). Similarly, the ATL strategy on international stocks would have produced a $280,000 after-tax benefit.
ATL offers investors a truly unique opportunity: to capture alpha in a systematic way that doesn’t rely on any guru or a lot of cost. The advisors at WRP have experience in ATL, and make it part of the global plan so clients can keep more money in their pockets to pass it on to the people they love or causes they care about. To read our ongoing updates about effective financial management practices, subscribe to our blog.