The small, volatile stocks that compose the Russell 2000 Index may make that benchmark a promising source of tax alpha,1 but turnover in small-cap indexes tends to be high.2 Does the turnover in the Russell 2000 offset the benefits of the volatility of its constituents?
To answer this question, we used ATBAT3 to look at the return and risk profiles of a tax-managed portfolio that tracked the Russell 2000, a popular small-cap index. By varying the start date of the back-test over the period beginning June 30, 1995, and ending September 30, 2018, we generated 54 runs of the small-cap index tracking strategy and two benchmarks. Relative to a portfolio that tracked the large-cap Russell 1000, the small-cap tracking portfolio generated more tax alpha (Figure 1) at the cost of substantially higher tracking error (Figure 2). To reduce tracking error, we constrained the Russell 2000 tracking portfolio by selling stocks as soon as they were deleted from the index. The difference in median tax alpha between the unconstrained and universe-only (UO) Russell 2000 tracking portfolios was just above 30 basis points. Even the median after-tax return of the small-cap portfolio was substantially higher than that of the large cap.
Figure 1: Ten-year tax alpha for tax-managed indexing strategies launched quarterly over the period June 30, 1995, to September 30, 2018.
Figure 2: Realized tracking error over 10 years in tax-managed indexing strategies launched quarterly over the period June 30, 1995, to September 30, 2018.
The universe-only constraint did far more damage to pre-tax active return, which was unexpectedly positive for the unconstrained Russell 2000 tracking portfolio. The source of the exceptional performance was rising stars: stocks that were promoted from the Russell 2000 to the Russell 1000 on the basis of great performance but remained in the tracking portfolio nevertheless. Unlike its tax-indifferent counterpart, a tax-managed small-cap indexing strategy will fight to hold on to rising stars in order to avoid realizing gains. The rising stars also accounted for the relatively higher tracking error in this portfolio, demonstrating that higher active risk can lead to better performance.
Figure 3: Ten-year pre-tax active return for tax-managed indexing strategies launched quarterly over the period June 30, 1995, to September 30, 2018.
A taxable investor tracking a broad market index like the Russell 3000 also benefits from holding a large number of volatile stocks. Between June 30, 1995, and September 30, 2018, average tax alpha in a 10-year tax-managed strategy tracking the Russell 3000 was 2.32%, close to the cap-weighted average tax alpha from the Russell 1000 and Russell 2000 tracking portfolios. The rising star alpha was hidden in the return of the Russell 3000 tracking portfolio.
Our ATBAT analysis supports the idea that a small-cap index tracking portfolio may be a superior source of tax alpha relative to its large-cap counterpart. It also indicates that absent constraints, rising stars generated exceptionally high pre-tax active return and tracking error.
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