After-Tax Asset Allocation

The calculation of after-tax asset allocation is key to determining asset location, which can significantly impact an investor’s after-tax returns according to a paper by William Reichenstein, Ph.D., CFA (a copy is here as well).   While this paper doesn’t mention the term “tax alpha” explicitly, it discusses some interesting tax management issues.  I have experience with developing technology and product strategy around managed accounts, so the author’s advocacy of after-tax allocation peaked my interest.

What the paper states is that funds going into a tax-deferred account, like a 401(k), should be adjusted by multiplying the amount by (1 – t_n), where t_n is the expected tax return in retirement.  So if you expect to be in the 25% tax bracket when you retire (assuming there is such a low bracket by the time you actually get to retire) you would multiply the pre-tax funds by 75% (1 – 25%) to account for future taxes.

So, if you had $2,000 to invest between a tax-deferred and taxable account, putting $1,000 into each account would not be an equal allocation using this method.  You would need to put somewhere around $1,140 into the tax deferred, which would be the same as $858 after-tax.  I know this doesn’t quite add up to $2,000, but I think this calculation would require a bi-nomial solution and I don’t have time to figure that out.  You get the idea anyway, I’m sure.

Seeking Tax Alpha

The term “tax alpha,” which was coined by Rob Arnott of investment manager Research Affiliates, represents the improvement in net returns gained from effective tax management. (from Seeking Tax Alpha By David E. Adler at AdvisorMax.com)

During my research and discussions with industry professionals, I’ve discovered (not surprisingly) that there are many definitions of tax alpha.

For example, according to an article that is also titled, Seeking Tax Alpha by John Phoenix, CEO of Metamorphosis Money Management (M3):

Tax alpha is the improvement of portfolio returns created by sound tax management: strategically harvesting stock losses for tax deductions by selling depreciated stocks at opportunities as they occur.

This definition seems limiting since tax harvesting is far from the only tax management method available to an investment manager.  Of course, one M3’s main sales tools is their focus on year-round tax harvesting.  So, this emphasis in John’s article is not surprising.

Is Tax Alpha a Myth or is it Real?

This blog is dedicated to a tax management as it relates to fee-based managed accounts.  I plan on researching and discussing many of the issues surrounding tax management.  I’ll look into tax management claims made by investment advisors, overlay managers and software companies.  Different methodologies of tax management are also on my radar as well as methods for validating claims that different management or optimization techniques can generate tax alpha.

The reason behind the name of this blog, “The Myth of Tax Alpha” came to me while I was attending the FRA’s Managed Accounts Technology & Operations Summit in February 2009.  A number of different speakers and panelists touted their firm’s ability to generate various amounts of tax alpha for their clients.  The range went from 10 all the way up to 300 basis points.  I thought this was an interesting topic and wondered if these claims could be verified or if they were just marketing fluff.  Maybe tax alpha is just a myth and maybe it’s not.  Either way I expect to learn a lot about tax management of managed accounts, so why shouldn’t I post it allonline and share it with all of you?