New research shows tax an important source of alpha –so can it be the new recruit to the alpha team?

Seeking ‘Tax Alpha’ is a viable strategy for superannuation funds, especially when traditional investment sources of alpha are difficult to generate, says new research from Parametric.

“If after-tax returns are recognised and accepted as the appropriate baseline for a fund’s investment focus, then the pursuit of tax alpha becomes part of the game plan that superannuation funds can seriously pursue,” explain the report’s authors, Raewyn Williams, Sydney-based Director – Research and After-Tax Solutions, and Seattle-based Hemambara Vadlamudi, Director of Research – Algorithm Development.

“In these volatile markets, superannuation funds need to exploit all the sources of market returns and investment ‘alpha’ (outperformance) available to them”.

“As a key element of this, it’s a simple intellectual exercise to recognise tax alpha as a lever funds can use to grow their members’ savings. Every dollar added closes the ‘retirement savings gap’, and members do not care how these dollars are added,” they detail in their 15-page report titled “The New Recruit to Your Alpha Team”.

Because funds are taxable, the authors contend, funds need to invest in an ‘after-tax world’ and as such, tax should be seen as untapped source of potential investment alpha. “Funds need to challenge their anchoring bias around pre-tax returns. That is not rational thinking in an after-tax environment,” says Williams.

The research shows tax is an important source of alpha, not the least because it can be added to existing pre-tax alpha sources so it is a “new, additive source” of returns.

“This differs from other alpha sources where a fund needs to make binary choices between ‘this alpha’ or ‘that alpha’ and hope these choices are right. Because tax alpha is generally additive, funds can keep their existing alpha sources and add tax alpha as well.”

In addition, the authors show that tax alpha possesses all the qualities of other good alpha sources – it is persistent, expected and harvestable in a range of market and fund scenarios. “We debunk the myth that funds need high turnover and/or portfolio overlap (redundancy) to generate tax alpha.”

The report argues that tax alpha is the result of particular skills and techniques, and cites eight examples where a tax-skilled manager can generate tax alpha in an investment portfolio:

• Tax lot selection – finding securities within a fund’s universe of holdings with the most favorable tax profile;
• Capital gains tax (CGT) discount targeting – determining, in the course of trading equities, whether delaying the trade would allow the tax rate on the trade to drop from 15% to 10%;
• Tax deferral – identifying where trades do not need to be done, or can be done in reduced quantities, or at a later time;
• Loss realisation – exploiting opportunities to crystalise an embedded tax loss by trading for investment reasons;
• Stock substitution – selling similar stocks with a better tax profile when the investment motivation for the trade is not stock-specific (such as to reduce a sector or factor exposure);
• Franking credit targeting ­– valuing franking credit yields on Australian equity portfolios;
• Buybacks and other corporate actions – electing corporate actions to support tax-efficient restructures and opportunities;
• Withholding tax management – minimising the ‘out of the market’ (or permanent) drag from withholding tax (WHT) deducted from foreign equity dividends.

Williams and Vadlamudi say that what the research shows is, that it is possible to turn the challenge of managing tax ‘on its head’ and target favourable tax outcomes as an untapped source of alpha. “Funds should see tax as a natural, harvestable part of the investment landscape rather than an issue they prefer not to think about”.

They conclude, “Of course, the magnitude of potential tax alpha is modest relative to the potential value-add of traditional (pre-tax) alpha sources, but a superannuation investor can use these methods to add tax alpha as a source of potential return while still preserving most or all of the traditional return sources”.

The complete paper is available here.