Factor Investing for Taxable Investors

Abstract

This article sets forth a practical framework for incorporating tax management into long-only factor investing and assessing the impact on tax efficiency and pre-tax returns. The framework premise is that investor views on the factor risk premium are represented by a tax-oblivious model portfolio. The model portfolio is then implemented in a separately managed account (SMA) by utilizing optimized, tax-efficient trading. The authors rigorously evaluate the impact of tax-managed model implementation on expected excess returns and risk on a both a pre-tax and after-tax basis. In particular, they extend the standard framework for covariance-based risk attribution to incorporate expected factor alphas and tax impacts. They find that tax-managed model implementation provides a boost to after-tax returns, more than fully mitigating model portfolio tax drag in most cases. Importantly, they also find that tax-managed model implementation does not degrade the capture of the factor premium, neither eroding the factor alpha nor meaningfully increasing risk of pre-tax underperformance relative to the benchmark.