The Tax Benefits of Separating Alpha from Beta

Abstract

We show using both simulated and historical data that separating active returns (i.e., alpha) from market exposure (i.e., beta) can have significant tax benefits. An investment strategy that separately invests into a passive index portfolio and an actively-managed long-short portfolio is more tax-efficient than a long-only actively-managed strategy with similar risk and style exposures. The turnover of a traditional active strategy causes capital gain realizations on both the active and the passive portfolio components. In contrast, the turnover of a strategy that separates alpha from beta is concentrated on the active long-short component and enables the deferral of capital gain realizations on the passive market component. Separating alpha from beta is an approach to tax efficiency that is different from systematic tax management described in the literature. It can provide a practical solution for taxable investors in a world dominated by tax-agnostic managers.

Keywords: Alpha-Beta Separation, Portable Alpha, Active Management, Long-Short, Long-Only, Tax Efficiency, After-Tax Performance

JEL Classification: G11, H21, H24