We believe that strategically managing taxes, including those incurred by investing and securities trading, can have a significant beneficial impact on long-term wealth growth. But every strategy needs a method for successful implementation, and for the tax-managed strategies at Neuberger Berman, those methods are tax loss harvesting and tax deferral, which generate “tax alpha.”
Generally speaking, tax alpha will be positive in a tax-managed portfolio, boosting after-tax returns by an estimated 2% per year. Indeed, it’s difficult to conceive how tax alpha could ever be negative. We all accept that traditional alpha can be negative: sometimes investors take portfolio risks that simply don’t pay off, and they underperform their benchmarks. But when it comes to paying tax, you either pay the full amount or find some way to save some of it—how could a strategy decision result in you paying more tax than you are liable for?
The answer is, it can’t. And yet it turns out that, in any particular month, tax alpha can be negative. Understandably, that often comes as a surprise to an investor in a tax-managed strategy—so let’s take some time here to explain what’s really going on.
What is Tax Alpha?
Before we dive into how tax alpha can be negative, let’s define what the term actually means.
Simply put, tax alpha measures the benefits of active tax management via tax-loss harvesting (realizing a loss by selling a security, which can then offset a taxable gain from another security) and tax deferral (delaying taxation so that money remains invested and continues to generate returns). To calculate tax alpha for our tax management strategies we take their total excess return over the benchmark and then then subtract the “pre-tax alpha” (the excess return coming from traditional active management) in order to isolate the benefits derived from tax-loss harvesting and gain deferral.
Figure 1. Calculating Tax Alpha
Source: Neuberger Berman. For illustrative purposes only.
How can tax alpha be negative?
The simplest example is when strategy guidelines are changed and that change temporarily makes the portfolio less tax-efficient than its benchmark. Examples might include a change to environmental, social and governance (ESG) policy or an instruction to track the benchmark more closely, both of which could force the sale of certain sectors or stocks. If those stocks have appreciated substantially while they’ve been in the portfolio, the sales result in an outsized tax liability.
This isn’t the only scenario that would cause negative tax alpha, however. A more subtle effect can follow a month of outsized tax harvesting.
How Tax Alpha is Spread Across the Entire Portfolio…
Consider a $1,000,000 portfolio that drops by $100,000 in January. The portfolio manager can harvest a tax saving from that $100,000 of loss: assuming a tax rate of 40%, $40,000 of the $100,000 does not have to be handed over to the tax authorities.
How does this work, in practice? Let’s say the portfolio’s gainers were up $50,000 and its losers were down $150,000. Without any tax management, the investor would owe $20,000 in capital gains tax on the $50,000 profit, despite having suffered a $100,000 loss overall. The amount of tax liability that can theoretically be offset due to $150,000 worth of losses is $60,000, which would leave the investor with a net gain of $40,000.
Now, the tax authorities don’t send the investor a check for $40,000. The gains that the $150,000 loss can offset in this portfolio specifically are limited to $50,000, or a $20,000 tax liability. Were this the investor’s sole portfolio, $20,000 would be all he could save. As long as there are gains in other parts of his portfolio, however, he can use the further $100,000 of losses to offset those—and if those gains elsewhere meet or exceed $100,000, he can claim the extra $40,000 tax saving in full.
The account for this specific portfolio would therefore show a value of $900,000 before tax, $880,000 after tax, and $900,000 after tax-loss harvesting—a net loss after tax of 10%. Economically, however, this portfolio has effectively created a value of $940,000—it’s just that this extra $40,000 shows up on the accounts for other parts of the investors’ holdings. That represents a net loss after tax of only 6%, or a tax alpha for January of four percentage points.
… And How That Can Lead to a Month of Negative Tax Alpha
It’s the fact that this $40,000 of tax savings is made elsewhere that can make one month’s positive tax alpha turn another month’s tax alpha negative.
Take a look at figure 2.
Figure 2. How Positive Tax Alpha in One Month Can Lead to Negative Tax Alpha in the Next
Source: Neuberger Berman. For illustrative purposes only.
Let’s assume the portfolio rebounds strongly in February, and appreciates by 10%, and that we don’t harvest any more losses during this time. Remember, this strategy’s account showed a value of $900,000, not the $940,000 of economic value it had created across the investor’s entire portfolio, and so after a 10% appreciation it would have a value of $990,000. After tax, we would add back the $40,000 of taxes saved in January, making its value $1,030,000. But the appreciation from $940,000 to $1,030,000 is 9.57%, not the 10% the investor would have gotten from not managing the tax liability at all. The tax alpha for January was four percentage points; but the year-to-date tax alpha for January and February combined was -43 basis points.
The extra $40,000 that was saved elsewhere hasn’t disappeared, of course. But because it is invested elsewhere, its gains or losses do not contribute to the performance of the tax-loss harvesting portfolio. It may have gained 10% in February, it may have gained 20%, it may have lost 50%—it simply doesn’t matter for the tax alpha of the tax-managed strategy account, where it will forever be worth $40,000.
For the most part, cash movements tend to exaggerate this effect. If the portfolio above were to experience an outflow of $400,000 at the end of January, its pre-tax value would have grown from $500,000 to $550,000, or from $540,000 to $590,000 after-tax. That’s a 10% appreciation without tax management, but only a 9.26% appreciation once the January tax savings are added back in—in other words, -74 basis points of tax alpha.
The simplest explanation for negative tax alpha, therefore, is when the portfolio is made less tax-efficient than its benchmark, usually due to specific and deliberate portfolio constraints.
It is important to remember the effect of interactions between losses harvested in one period and returns made in another, however. It may seem counterintuitive, and it is an accounting effect rather than a real economic effect, but these interactions can leave investors nursing a negative alpha from a process that, on the face of things, appears to be an uncomplicated, riskless way to preserve economic value for the portfolio.