The Big Picture
We’ve received a lot of great questions in response to our November 21 Client Research Call on how the FIFO (first-in, first-out) provision in the US Senate version of the Tax Cuts and Jobs Bill might affect a tax-advantaged indexing strategy. The topic that has come up most frequently is the addition of fresh cash to an existing portfolio. Taxable investors know well that since US and global public equity markets have trended upward historically, the FIFO rule would have diminished the positive impact of deposits on tax alpha. The question is, by how much? While every case is different, we can get a feel for the size of the impact by looking at a few examples.
- 1 Tranche: tax-advantaged indexing strategy with initial funding of $10 million (no additional deposits, considered in our first post on FIFO)
- 2 Tranches: 1 Tranche plus a deposit of $5 million at year five
- 3 Tranches: 1 Tranche plus two deposits of $3 million at years one and two
- 4 Tranches: Investment of $3 million at inception plus additional deposits of $3 million at three, six, and nine months (dollar-cost averaging)
Figure 1: Median after-tax alpha of hypothetical tax-managed indexing strategies with lowest tax liability and FIFO loss harvesting. June 1995–July 2017. Sources: MSCI and Aperio Group.
We used Aperio’s After-Tax Back-Testing Analysis Tool (ATBAT) 1 to measure tax alpha of four tax-advantaged S&P 500 indexing strategies at a range of different 10-year horizons with lowest tax liability and FIFO loss harvesting methods; summarized results are shown in Figure 1. Median after-tax alpha for 48 runs over the period from June 1995 to July 2017 was just over 2.50 percent for the deposit strategies that used the lowest tax liability method (orange bars), while it ranged between 2.35 percent 2.41 percent for the FIFO method (blue bars). Note that the tax alpha measured reflects changes in returns for the entire portfolio, not just any incremental deposit. We’ll be analyzing that incremental tax alpha in more detail in future research.
The Gory Details
Table 1: Distribution of after-tax alpha and differences in after-tax alpha for hypothetical tax-managed indexing strategies with lowest tax liability and FIFO loss harvesting. June 1995–July 2017. Sources: MSCI and Aperio Group.
Focusing on the strategy with 2 Tranches, we consider in Table 1 how FIFO would have affected the full range of outcomes for tax-managed indexing strategies with and without cash deposits. Adding a deposit of $5 million five years after an initial investment of $10 million increased after-tax alpha across the boards, but it diminished the median difference between lowest tax liability and FIFO by 0.19 percentage points in the presence of a cash flow, and by 0.04 percentage points when no fresh cash was added. In contrast, the worst-case differences between lowest tax liability and FIFO were 0.47 percentage points and 0.46 percentage points with and without cash deposits, respectively. This is representative of many examples that we considered: FIFO had a greater impact on the median case when fresh cash was added, but it did not exacerbate the worst case.
The Impact of FIFO on Tax Alpha in a Mature Strategy
Figure 2: Scatter plot of FIFO-induced relative decline in direct tax alpha accumulated in years five through 10 of a 2-Tranche strategy against the cumulative return to the S&P 500. Sources: MSCI and Aperio Group.
Finally, we take on the practical question, “If the FIFO requirement becomes law, should I still add cash to my tax-advantaged indexing portfolio if I had intended to do so previously?” To address this, we look at the impact of FIFO on direct tax alpha, 2 the accumulated value of harvested losses, in years five through 10 of a 2-Tranche strategy. Using lowest tax liability as a benchmark, FIFO diminished direct tax alpha by somewhere between 10% and 85%, depending on index performance. Poorer index performance was associated with lower impact. So even in a rising market, FIFO did not completely eradicate the positive impact of fresh cash; but for the most part, the negative impact was worst in years with the highest index returns.
No one is surprised by the finding that, relative to lowest tax liability, FIFO is a less-effective method of harvesting losses. Our growing library of ATBAT tests indicates, however, that the damage may be contained, even for indexing strategies with fresh cash added along the way.
As I write this, Aperio’s research team is analyzing the impact of FIFO on factor tilts and SRI tilts; we’re looking at a range of benchmarks and different investment horizons; we’re measuring the impact of changes in state taxes and alternative minimum tax (AMT) on loss harvesting. We’re optimizing our loss-harvesting algorithms to make the best of FIFO, in case it becomes the law. Stay tuned for updates.
- Listen to Patrick Geddes, Chief Tax Economist, and Ran Leshem, CIO, discuss this topic in our Client Research Calls:
- FIFO Update #1: The Impact of FIFO on a Tax-Managed Indexing Strategy
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