(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.
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.
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.
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
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.
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.
Listen to Patrick Geddes, Chief Tax Economist, and Ran Leshem, CIO, discuss this topic: Webinar (20:11)
Send questions or comments to email@example.com.