Is Your Alpha Big Enough to Cover Its Taxes? A Quarter-Century Retrospective

Key Points

  • Deferring taxes is like receiving a free loan from the government.
  • The tax burden can be reduced by limiting turnover, reducing dividend yield, and investing in smaller, more-tax-aware funds.
  • Smart beta has emerged as an investment category with the potential to deliver positive alpha after fees and taxes.
  • Exchange-traded funds provide tax efficiencies that mutual funds lack.


Costs matter to every bottom line, and investment management is no exception. Costs—both implicit, such as trading-related market impact costs, and explicit, such as management fees and stated trading costs—lower bottom-line investment returns, and one of the largest costs for any taxable investor is taxes. In the seventh article of our advisor series, we discuss how to identify tax-efficient managers and describe the investment vehicle structures best designed to deliver after-tax alpha. This article draws substantially on the Spring 2018 Journal of Portfolio Management article of the same title written by Rob Arnott, Vitali Kalesnik, and Trevor Schuesler.

Twenty-five years ago in the article “Is Your Alpha Big Enough to Cover Its Taxes?” Tad Jeffrey and I published our findings on the impact taxes have on investment returns. We called this ever present burden on investors “tax alpha,” which is reliably negative. The good news, however, is that now, as then, the tax burden arising from realized capital gains and dividend income is surprisingly easy to shrink. Diligence in deferring capital gains, loss harvesting, lot selection when selling, wash-sale management, holding period management, and other tax-aware strategies can substantially lower the government’s cut of investors’ returns and allow investors to keep more of what their portfolios have earned.

Since 1993, a growing awareness by managers of the importance of tax efficiency, new investment strategies such as smart beta, and innovative investing structures such as exchange-traded funds have all improved investors’ ability to reduce the tax bite into investors’ returns. But other things haven’t changed over the last 25 years. Active managers still have a hard time consistently generating pre-tax alpha, and the fees of active managers are still high. Therefore, for investors to earn the highest possible after-tax return, they and their advisors must consider all additions to, and subtractions from, the following equation:

Gross-of-Fees Return

– Fees

– Income Tax on Dividends and Capital Gains Tax

– Capital Gains Tax After Liquidation

= After-Tax Return

Consequently, an advisor’s ultimate goal should be to shrink the tax-alpha drag on their investors’ portfolios without forfeiting pretax alpha!