Tax Management - Optimized for Investors


  • Academic studies of portfolio management often neglect real world considerations.
  • Turnover is often used to gauge tax management capabilities, but used in isolation turnover can be misleading.
  • Tax lot accounting is integral to maximizing after-tax returns.
  • Tax management must be an integral part of a manager’s buy/sell discipline, and should be applied throughout the year.
  • OSAM’s after-tax results in 2013 are indicative of an effective, integrated tax management process.

Tax season is once again upon us. It is a stressful time for Americans who need to go through reams of documents and statements in order to ensure they are not giving away any more of their hard earned money than is necessary. The tax code within the U.S. has become so laborious over the years that it has helped fuel a tax preparation industry that now brings in over $9 billion in revenue from taxpayers hoping to hold on to some extra cash. Yet for as much focus as Americans have on their annual tax bill, investors pay little attention to how asset managers work to minimize their taxes. OSAM’s investment philosophy is based on rigorous historical studies that identify which stock character-

istics have offered strong excess returns, risk-adjusted returns, and a high degree of consistency of outperformance versus the market. The firm then applies that research into clients’ portfolios by taking into account real world circumstances, such as taxation.

In this paper, we will evaluate how investors can mitigate their tax impact while still realizing strong consistent returns from sound investment strategies. Our goal is to marry proven quantitative investment strategies with a common sense implementation that helps prevent returns from being unnecessarily eroded by taxes.


Many well-known academic studies focus on the generation of excess returns on the stock market “in a frictionless world.” This means that their studies often don’t account for transaction costs, stock liquidity, and the tax impact of a trading strategy. However, those are very real considerations that must be taken into account when investing. Those various “frictions” can have huge implications on a client’s portfolio—effective tax and transaction cost management is key to realizing the benefits of any quantitative investment strategy. Another beneficial aspect of managing a portfolio for taxes is that the outcome is known and identifiable, assuming you are educated on the tax code. Even the best investment strategies will come in and out of favor over the short term, leaving times where they may not add value to investors. This variability does not exist when it comes to taxes, however. A manager knows ahead of time the impact of realizing capital gains within a portfolio. Portfolio managers who are aware of taxable events can help ensure a tax benefit to the client by either not selling a position if it won’t substantially create alpha, or waiting until the position can be sold at a more beneficial tax rate.


On the following page, Table 1 helps illustrate the point that, if fund managers disregard whether a sale in the portfolio is being taxed at a long- or short-term rate, there can certainly be negative implications to their taxable investors. The scenarios shown in the table hold constant the portfolio returns and portfolio turnover, but vary the percentage of the realized portion of the returns that are long term.

Simply limiting the amount of short-term gains realized in the portfolio can substantially increase the after-tax return of a portfolio. In Table 1, shifting taxable gains from short to long term enhanced the after-tax return by 1.4 percent. Applying the assumptions above on a $250,000 portfolio over five years, that translates to a cumulative tax savings of $29,415. Tax management is not just about holding everything long term. What is not considered in the above analysis is the ability to realize net short-term losses within client portfolios. Short-term losses can be used to offset their long-term gains in the current tax year or carry forward to apply to future tax years.


The most common criteria for evaluating manager tax efficiency is turnover. Portfolio turnover is defined as the lesser dollar value of buys or sells, divided by average market value. While we agree that excessive turnover can be destructive to portfolios, we believe the usefulness in assessing the impact of turnover on after-tax returns is overstated. First, turnover allows managers to stay “true” to their investment philosophy as the market changes. At OSAM, we believe that investing in companies that have attractive characteristics such as low valuations, strong financial strength, and high earnings quality leads to outsized returns in the market over time. In order to remain invested in names with the most attractive characteristics we need to adapt and allow the portfolio to move out of names that have deteriorating quality or valuations and into new names in which we have greater conviction. In addition to being an alpha driver, turnover can periodically be advantageous for tax purposes. Realizing losses in a portfolio can serve as a key reserve with which to pair against realized gains throughout the year (note the emphasis on the term “throughout”). Tax management should not be an end-of-the-year afterthought. Continual tax management allows us to opportunistically harvest losses that can be used to offset gains throughout the current year and can be carried forward to future years. For example, in 2013 the O’Shaughnessy Enhanced Dividend® strategy returned 16.6 percent (gross of fees), yet we were able to realize on average a net short-term loss across client accounts by harvesting losses throughout the year. To illustrate, within a representative Enhanced Dividend account we sold 25 percent of our Deutsche Telekom (DTEGY) position on a short-term basis and realized a loss of 4.95 percent in February 2013. If we only harvested taxes at year end, we would have lost our opportunity to book an offsetting short-term loss—the stock then roared through the end of the year, returning 63.75 percent for the full year 2013. By taking advantage of the negative cost basis in February, we were able to realize the loss for the client as an offset and we also participated in Deutsche Telekom’s rally by holding the remaining 75 percent of the position. Deutsche Telekom remains within the portfolio, but will then be taxed at the long-term capital gains rate, if and when it gets traded out in favor of a better opportunity. Harvesting throughout the year can also help avoid pushing a manager far from his model at year end when a tax harvest request is received. Often managers are forced to either leave the proceeds of the tax harvest in cash or invest them into an ETF. In other words, the manager and/or client is being forced to make an extremely short-term market-timing decision. We prefer staying fully invested in the best current opportunities (our model portfolio) rather than straying away from an ideal portfolio. In addition to harvesting short-term losses, we try to defer short-term gains to the more advantageous long-term tax rate. Some of OSAM’s strategies have a growth component (for example, All Cap Core)—in these cases, momentum is used as a factor for selecting stocks. Our research shows that stocks with strong recent price performance and a relatively low volatility profile have outperformed the market over time. Momentum is a very strong-performing factor in our testing, but leads to higher turnover in portfolios. Managers using momentum are likely to turn over names quickly and on a short-term basis for their clients. OSAM’s techniques differ from that approach—we seek to avoid these short-term gains where possible. Figure 1 illustrates the lifecycle of one of the names selected for the O’Shaughnessy All Cap Core portfolio based on its momentum.

Figure 1: Example — Mohawk Industries (MHK)

We began to purchase in Mohawk Industries (MHK) in December 2012 and continued to purchase the name as our conviction increased through March 2013. After that point, the name began to slowly reduce its weight in our model. In a “frictionless world” (with no taxes) this means we would start to sell the position in April or May. As shown in the chart, we held the position’s weight in order to avoid negative tax implications. After March, the divergence between the model weight and the portfolio weight is due to recognizing the tax benefit of holding this position on a long-term basis. It is not until after-tax lots begin to go long-term that the gap starts closing. In this example, we were able to reduce the tax bill on one of the top-performing names in the portfolio.


In order to properly account for taxes for clients, money managers need to monitor their positions at the tax lot level. A tax lot analysis allows managers to determine whether transacting in a name is worth the amount in taxes it is going to cost. Tax management is becoming more important as taxes on investors are steadily raised. Although the United States was able to avoid going over the “fiscal cliff” at the end of 2012, investors paid a price. The top marginal tax rate was increased from 35 percent to 39.6 percent and the tax rate of qualified dividends and long-term gains jumped from 15 percent to 20 percent for top earners. On top of those increases, the Affordable Care Act adds an additional 3.8 percent tax for top earners.

OSAM utilizes several methods in an effort to help our clients avoid excessive taxes on their portfolios. The methods shown here are implemented across all of our strategies for taxable investors and are designed to help clients capture the best after-tax return on their portfolios:

Defer the realization of taxable gains until they go long term

Whenever possible, OSAM restricts the sale of a stock that is in a short-term gain position to the client so as not to impose the higher short-term tax rate. When this happens, we will hold names relative to our strategy model because we have found that the impact of the higher short-term tax rate can erode the additional alpha of executing a sale.

Target short-term losses within the portfolio to sell

Upon every rebalance that OSAM executes we strategically target selling short-term losses within the portfolio so the client can use these as an offset. Short-term losses can be used to net against short-term gains the client may have across their investments. After netting against short-term gains, if there are additional losses across their portfolio, the client can use those to net against long-term gains, or use them as a carryover for taxes in future years. The pecking order we establish when selling securities is to first seek short-term losses, then long-term losses. If there are no losses available we will look to realize long-term gains and, as a last resort, realize short-term gains.

Avoid wash sales when possible

In order for a client to actually realize the tax benefit of realizing a loss wash sale, rules must be obeyed. A wash sale occurs when a stock is sold at a loss and, within 30 days before or after sale, you also purchase the same stock. While these are sometimes unavoidable due to client-driven cash requests, or stocks being liquidated due to a red flag, OSAM restricts purchases in a name that was sold to target a loss.


2013 was one of the strongest on record for equity returns—the S&P 500 returned 32 percent, its third highest annual return in the past 30 years. Despite this strong price movement throughout the year, OSAM was able to mitigate the short-term tax impact to client portfolios by utilizing the tools described above. Table 2 shows the results, grouped by taxable accounts that were open for the entire year 2013.

Several of the strategies returned well over 40 percent for the year, yet the short-term realized gain divided by market value of the account (% short-term gain) were all below 2.5 percent. Enhanced Dividend—which lagged the market in 2013 but still posted a 16.6 percent (gross of fees) return—was able to realize a net short-term loss for our taxable clients that could either be applied to their long-term gains in that strategy or gains they had elsewhere during the year. All Cap Core—which had stellar results in 2013, returning 44.2 percent (gross of fees)—was able to keep its short-term gain below one percent of the total market value. Those are significant tax savings for a strategy that, if it were managed tax agnostic, would see significantly more short-term impact.


We believe that active management works when the right strategy is paired with a strong discipline to the investment thesis. However, excessive taxes can erode alpha. Therefore, when managing active portfolios, managers must be aware of the tax implications of their transactions in order to give their clients the strongest after-tax return. We continue to manage portfolios mindful of the ever-changing U.S. tax code and its impact on our clients’ investments.

By emphasizing tax management throughout the year, and making trading decisions at the lot level, we believe we can continue to use our proven strategies to deliver the best possible real world results.

General Legal Disclosure/Disclaimer

The material contained herein is intended as a general market commentary. Opinions expressed herein are solely those of O’Shaughnessy Asset Management, LLC and may differ from those of your broker or investment firm.

Please remember that past performance is no guarantee of future results. This commentary has been compiled purely for informational purposes only. You should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, individualized investment and/or tax advice from OSAM. In preparing this commentary, OSAM has relied upon information provided by the account custodian and/or third party service providers. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional tax advisor and/or investment professional of his/her choosing. Moreover, different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this commentary, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for any portfolio. Gross of fee performance computations are reflected prior to OSAM’s investment advisory fee (as described in OSAM’s written disclosure statement), the application of which will have the effect of decreasing the composite performance results (for example: an advisory fee of 1% compounded over a 10-year period would reduce a 10% return to an 8.9% annual return). Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that any account holdings would correspond directly to any comparative indices. Tax and investment information has been compiled solely by OSAM, has not been independently verified, and does not reflect the impact of taxes on non-qualified accounts. OSAM is a Registered Investment Adviser with the SEC and a copy of our current written disclosure statement discussing our advisory services and fees remains available for your review upon request.

The dividend yield is a gross indicated yield. There is no guarantee that the rate of dividend payment will continue and the income derived is subject to taxes and expenses which will impact the actual yield experience of each investor.

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