In the quest for higher returns, investors often prioritize stock selection or market timing. However, increasing research indicates that a more understated or overlooked strategy – tax-aware investing – could be the key to significantly boosting your portfolio’s performance. Studies show that tax alpha, achieved through tax-loss harvesting can enhance performance by potentially adding 1% to 2% in annualized after-tax returns, particularly in volatile markets. Let’s explore the compelling case for tax alpha, combining industry-leading research with Alphathena’s own findings.
Defining Tax Alpha
Before we delve into the numbers, let’s clarify what we mean by “tax alpha.” Tax alpha is the extra after-tax return that’s generated by implementing tax-efficient investment strategies compared to a standard benchmark portfolio. Simply put, it’s the additional money you save by being strategic about taxes.
This is typically accomplished using a strategy called Tax Loss Harvesting, in which securities that lose value are sold and replaced by other securities that don’t materially change the constituent makeup of the portfolio, after carefully considering other factors such as wash sales, tracking error, and security restrictions.
The Academic Perspective
Academic research and industry studies consistently highlight the potential of tax-aware strategies and industry giants have also reported similar results:
- Chaudhuri, Burnham, & Lo (2020) estimated that tax-aware strategies could add between 0.85% to 1.10% to annual returns.
- More recently, CFA Institute published a summary article on “An Empirical Evaluation of Tax-Loss- Harvesting Alpha” published in the 3rd quarter of 2020 and found that these strategies could boost after-tax returns by up to 2% annually.
Leading investment firms have also conducted their own research, and their results are equally impressive:
- Parametric Portfolio Associates LLC (2021) estimated a 1.9% annual tax alpha from their strategies.
- Vanguard Research (2020) suggested a range of 0.5% to 1.5% in additional after-tax returns.
- BlackRock (2018) went even further, claiming up to 2.5% annual tax alpha during high volatility periods.
Tax Alpha in Practice
Our analysis at Alphathena strongly aligns with these industry findings, revealing consistent tax-loss harvesting opportunities in the S&P 500 from 2020 to 2024. The data highlights several key insights:
Volatility as a Catalyst: In the notably volatile year of 2022, approximately 91% of S&P 500 components experienced a decline of 5% or more, creating substantial tax alpha opportunities. This underscores how market turbulence can be strategically leveraged to enhance after-tax returns.
Opportunities in Bull Markets: Even in strong market conditions, tax-loss harvesting remains viable. For instance, during the bull market of 2021, nearly half (49.8%) of S&P 500 stocks still offered loss harvesting potential.
Persistent Potential: Recent data from 2023 and 2024 shows ongoing opportunities, with 74.8% and 64.9% of holdings respectively presenting harvesting potential. This indicates that the potential for tax alpha persists even as markets recover.
Market-Agnostic Strategy: Our findings demonstrate that tax-loss harvesting can be effective across various market conditions, allowing investors to potentially benefit in both up and down markets.
The table and graphic “Tax Loss Harvesting Opportunities” compares the total number of constituents for the ETF during each calendar year, with the number of constituents considered a tax loss harvesting opportunity during the same calendar year. An opportunity is calculated as any unique constituent that dropped 5% in value since the beginning of the calendar year.
The accompanying graph and table visually reinforce these points, illustrating the year-by-year fluctuations in harvesting opportunities and its prevalence across different market cycles. This data supports the argument that a well-executed tax-loss harvesting strategy can consistently add value to investment portfolios, regardless of broader market trends. Our research at Alphathena shows that there are indeed opportunities to generate these tax alpha returns.
Tax-aware investing, enabled by platforms like Alphathena, provides a systematic approach to potentially boosting after-tax returns, regardless of market conditions. By prioritizing what investors retain over what they earn, tax alpha strategies can have a substantial impact on long-term financial outcomes. As markets shift and tax regulations evolve, integrating tax-aware strategies into investment plans becomes essential for maximizing returns and efficiently achieving financial goals.