Figuring out how to not pay taxes is my favorite topic.
Before I continue, if you want to read a detailed study on the subject, see the following:
If you want to read my "Barney Style" study, keep on reading...
Quick study on tax efficient rebalancingLet's pretend you have an annually rebalanced quant strategy--go long top 200 low asset growers in the investment universe, for example. The strategy seems simple enough, but how does one rebalance the portfolio each year?
I went ahead and did a simplified study of tax-efficient yearly rebalancing vs. tax-inefficient rebalancing.
Here is a summary of the approach (which isn't meant to reflect perfect reality, but to prove a basic point):
- I do 1000 simulations of 10 years of annual returns with a mean of 10% and a standard deviation of 20% (roughly what the market does each year).
- I assume long-term cap gains are 20%, and short-term cap gains are 40%.
- The efficient portfolio works as follows: if it is a loser year, the portfolio liquidates at 364 days, pays taxes, and rebalances the next day; if the portfolio is a winner year, it liquidates at 366 days, pays taxes at the end of the tax year (build in deferral), and rebalances that next day.
- I assume there is 100% turnover to avoid wash sale complications (e.g., none of the stocks in the previous portfolio, show up in the 'fresh' portfolio).
- I also allow realized losses to carry over from year to year to be applied against gains within the 10-year window of each simulation (so each 10-year simulation outcome is path dependent).
- The inefficient portfolio liquidates at 365 days each year, eats a 40% tax bill, and rebalances.
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.In this simple setup, simply rebalancing in a tax efficient way adds 2-5%+ CAGR to your after-tax return--over a 10, 20, or 30-year period, that is some SERIOUS MONEY!
- Stop reading this blog trying to find alpha...
- Go out there and find a great tax attorney and CPA!!!
If you liked this post, don't forget to subscribe to Alpha Architect
Alpha Architect believes in a systematic, evidence-based, and fully transparent approach to asset-management. Please contact us to learn more
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees.
This information is not intended to, and does not relate specifically to any investment strategy or product that Alpha Architect offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.