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Tax alpha: How to measure it and maximize it

Timely insights on the issues that matter most to investors.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Rey Santodomingo, Director of Investment Strategy - Tax Managed Equities, Parametric

      Seattle - Many index investors are looking for more tax-efficient ways to invest. That sounds great in theory, but how do you know if it's working?

      While managers of index-based portfolios can harvest losses, either annually or on a continuous basis, as part of a tax-management process, measuring the actual value to your portfolio isn't always apparent. One way to quantify the effectiveness of tax management is by using tax alpha.

      Measuring tax alpha

      Parametric defines tax alpha as the portfolio's excess after-tax return, relative to its benchmark, adjusted for any excess pretax returns.

      Tax Alpha = Excess After-Tax Return - Excess Pretax Return

      Over the long term, excess pretax returns should be close to zero, but they can fluctuate during shorter time periods because opportunities for tax-loss harvesting can vary. Subtracting this "noise" allows us to more accurately capture the impact of active tax management.

      This also ensures that tax alpha isn't swayed by the portfolio's pretax outperformance or underperformance, since neither is relevant in terms of the value of tax management. Simply put, tax alpha is positive only if the excess after-tax return is greater than any excess pretax return. In periods with no excess pretax return, tax alpha is simply the excess after-tax return.

      Maximizing tax alpha

      The size of an investor's tax alpha depends on two key factors: the direction of the overall equity market and the magnitude of individual stock volatility.

      All else being equal, a falling market increases the probability of losses in an investment portfolio and a rising market decreases that probability. So in falling markets there are more opportunities to harvest losses and thereby increase tax alpha.

      If we were to hold market returns steady, we'd be able to observe how stock volatility affects tax alpha. The higher the stock-level volatility, the more likely that stock will fall into a loss position over a given period.

      In a real-life scenario, however, one in which portfolios experience both market movement and dispersion between stocks, tax alpha is maximized when the markets are falling and dispersion between stocks is high.

      Bottom line: For index-based portfolios, tax alpha can be an effective way to measure the value of active tax management, and there are scenarios in which it can be maximized. However, every investor's circumstances and objectives are unique. That being said, over our close to three decades of tax-management experience, we think tax alpha can help not only illustrate the potential outcomes of active tax management but also set realistic expectations based on the market environment.