FIFO Update #1

Active Tax Management

FIFO Update #1

The Impact of FIFO on a Tax-Managed Indexing Strategy

November 20, 2017

Executive Summary
(Yes, we know that executive summaries don’t belong in blog posts, but we’ve got to get this information out somehow.)

  • The US Senate version of the Tax Cuts and Jobs Bill includes a provision that disallows specific tax lot identification and instead requires FIFO (first-in, first-out).
  • We’ve modelled the impact of the proposed rule on our tax-managed indexing strategy funded with cash in the US market on our back-testing platform (ATBAT). At a 10-year horizon, the median after-tax alpha was 2.26% with the lowest tax liability rule and 2.22% with FIFO over the period June 1995 through July 2017.
  • The relatively small impact of FIFO on after-tax alpha indicated by our back-test of an all-cash strategy is consistent with our analysis of live strategies: since 2007, would have affected only 30% of trades in Aperio’s taxable accounts.

The Proposed Change

The tax reform bill under consideration in the US Senate includes a first-in, first-out (FIFO) rule for the sale of public equity. If adopted, the provision will require an investor who is partially liquidating a position to sell the oldest shares first. Under the current law, investors can use FIFO or select specific lots during the liquidation process. The latter can be designed to create the lowest tax liability. The analysis below quantifies the impact of the new rule on a tax-managed indexing strategy in the US market.

ATBAT Historical Simulation with and without FIFO

Our analysis is based on a historical back-test that compares the performance of hypothetical tax-managed indexing strategies using FIFO and lowest tax liability.1 Both strategies can sell lots to reduce tax liability taking into account losses, term, tax rates, and risk, but the FIFO strategy limits flexibility by forcing older shares to be sold first. Since a taxable strategy is sensitive to its age as well as market attributes such as turbulence, we aggregate results over many periods, and we display performance statistics at different investment horizons. Specifically, we launch tax-managed indexing portfolios quarterly, funded with cash, tracking the S&P 500,2 beginning in June 1995 and ending in July 2017, and we display results at 5- and 10-year horizons.3 To avoid risk associated with leverage, we disallow short positions, and we set tax rates at the highest US Federal capital gains level as of November 2017.4

We consider two performance metrics. The first is after-tax alpha, the difference in return between a portfolio and its benchmark after tax.5 This is the spendable benefit that a tax-managed strategy delivers to an investor. In Figure 1, we show the median values of after-tax alpha delivered historically by the hypothetical strategies. At both the 5- and 10-year horizons, FIFO diminished the median after-tax alpha by 0.08 and 0.04 percentage points respectively. This represents a 3% reduction in after-tax alpha at both horizons.

after tax alpha

Figure 1: Median after-tax alpha of a hypothetical tax-managed indexing strategy with lowest tax liability and FIFO. June 1995–July 2017. Source: MSCI and Aperio Group.

The second performance metric is tracking error,6 which measures the risk that the tax-managed portfolio will deviate from its benchmark. In Figure 2, we show the median values of forecast tracking error attained historically by the hypothetical strategies.

forecast tracking error

Figure 2: Median forecast tracking error of a hypothetical tax-managed indexing strategy with lowest tax liability and FIFO. June 1995–July 2017. Source: MSCI and Aperio Group.

At both 5- and 10-year horizons, the FIFO rule led to an increase in median tracking error by 0.03 percentage points. That translates to a 7% increase at a 5-year horizon and 5% increase at a 10-year horizon.

Conclusion

In our historical back-test,7 the FIFO rule diminished the return of tax-managed indexing strategies and increased their active risk, as expected. However, the apparent magnitude of the impact in our historical back-test seems to indicate that even if the FIFO rule is required, tax-managed indexing strategies will continue to deliver value to taxable investors.

We are currently investigating any possible impact on additional strategies and scenarios including cash deposits (the impact on loss harvesting of additional cash flows), factor-tilted strategies and portfolio liquidation.

Aperio’s systems and processes can work with multiple tax lot relief methodologies including FIFO. If the proposal becomes law, we will work with advisors to ensure a smooth transition. For now, Aperio will continue its normal portfolio rebalancing. In any case, the optimal strategy will be to harvest losses using the current methodology for the remainder of the year.

The Gory Details

Over the period June 1995 through July 2017, the ATBAT historical simulation produced 68 observations of hypothetical after-tax alpha and tracking error at a 5-year horizon, and 48 observations at a 10-year horizon. In Tables 1 and 2 below, we show the ranges of the observations. The "Difference" column refers to the range of observed differences.8

after tax alpha

Table 1: Distribution of after-tax alpha for a hypothetical tax-managed indexing strategy with lowest tax liability and FIFO. June 1995–July 2017. Source: MSCI and Aperio Group.

after tax alpha

Table 2: Distribution of forecast tracking error for a hypothetical tax-managed indexing strategy with lowest tax liability and FIFO. June 1995–July 2017. Source: MSCI and Aperio Group.

Additional Resources

Listen to Patrick Geddes, Chief Tax Economist, and Ran Leshem, CIO, discuss this topic: Webinar (20:11) lock icon

 

Send questions or comments to blog@aperiogroup.com.

1 The analysis is carried out on ATBAT, Aperio’s after-tax back-testing platform. The risk forecasts were generated by the Barra US Total Market Equity Model for Long-Term Investors and the portfolios were constructed with the Barra Optimizer.
2 The S&P 500® Index is an equity benchmark for US stock performance. It is a capitalization-weighted index covering 500 large US companies chosen by Standard & Poor’s for market size, liquidity, and industry group representation. You cannot invest directly in an index.
3 We have 68 runs at a 5-year horizon and 48 runs at a 10-year horizon.
4 Our portfolio construction is based on a factor-based optimization that balances the competing goals of harvesting realized losses and minimizing tracking error against a diversified benchmark.
5 The results reflect disposition through an estate or a charitable donation, meaning that no income tax is paid at disposition.
6 We report pre-tax post-trade forecast tracking error.
7 Our historical back-test is conservative in the sense that it does not include strategy adjustments or enhancements intended to mitigate the impact of the FIFO rule.
8 Differences in extreme observations need not be a good indicator of extreme differences.

This article is provided for informational purposes only. The information contained within this article was carefully compiled from sources Aperio believes to be reliable, and it is accurate to the best of our knowledge and belief. However, Aperio cannot guarantee its accuracy, completeness, and validity, and cannot be held liable for any errors or omissions. All information contained herein should be independently verified and confirmed. Aperio does not accept any liability for any loss or damage whatsoever caused in reliance upon such information. Aperio provides this information with the understanding that it is not engaged in rendering legal, accounting, or tax services. In particular, none of the examples should be considered advice tailored to the needs of any specific investor. Aperio recommends that all investors seek out the services of competent professionals in any of the aforementioned areas. With respect to the description of any investment strategies, simulations, or investment recommendations, Aperio cannot provide any assurances that they will perform as expected and as described in this article. Past performance is not indicative of future results. Every investment program has the potential for loss as well as gain.