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Why investment taxes are such a drag

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 SantodomingoDirector of Investment Strategy - Tax Managed Equities, Parametric

      Seattle - What's the value of tax-managed investing?

      It's funny, because it's something we pioneered and have been doing for our clients for more than 25 years, but we still get this question a lot. The answer is simple: Tax-managed investing can be of immense value. In fact, thanks to relatively high rates on capital gains, investment taxes can represent a larger drag on investment returns than fees or trading costs. The timing of cash flows and the gains or losses embedded in the portfolio can also affect the amount of taxes investors owe.

      Yet despite advances in tax-management theory and practice, many managers continue to ignore investment taxes. Instead they focus exclusively on pretax performance and are reluctant to report after-tax performance. For these managers the pretax alpha they generate isn't large enough to cover the tax consequences of pursuing the excess return.

      What causes tax drag?

      Portfolio turnover — the very activity designed to enhance returns — is, ironically, the primary cause of tax drag. The portfolio manager sells one asset, potentially incurring a tax obligation, and buys another based on the belief that the trade will benefit the investor. In many cases, however, the tax incurred turns out to be larger than the (unknowable) additional return potential of the trade. When we evaluate the impact of taxes on investment outcomes, it makes sense to question whether the average manager's alpha compensates for the tax repercussions.

      Measuring the impact of tax management

      The ability to measure the impact of investment taxes objectively is a critical component of a tax-efficient investment strategy. Attributing after-tax performance to a manager's tax-management skill requires an after-tax benchmark.

      A manager's potential tax alpha — the difference between the after-tax and pretax excess returns of the portfolio versus the benchmark — depends largely on that manager's ability to do two things: take advantage of loss opportunities and avoid gain realization. The level of a manager's tax alpha depends to some extent on market volatility. The higher the stock-level volatility, the more likely a particular stock will fall into a loss position over a given time period. In a real-life scenario, where portfolios experience both market movement as well as dispersion between stocks, tax alpha is maximized when markets are falling and dispersion between stocks is high.

      Yet the value of tax management is more than a measure of tax alpha. While loss harvesting allows us to reduce taxes in earlier time periods, the economic impact of these reduced taxes grows over time. By not only looking at tax alpha but also being mindful of the compounding effect of deferral, we can measure the entire all-in value of tax management.

      Bottom line: There's a material benefit to paying attention to taxes and harvesting losses throughout the year to help make investment taxes less of a drag.