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Rising Star Alpha: Loss Harvesting in a Small-Cap Index

Active Tax Management
April 18, 2019

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.

Median Tax Alpha

Figure 1: Ten-year tax alpha for tax-managed indexing strategies launched quarterly over the period June 30, 1995, to September 30, 2018.

Median Tracking Error

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.

Median Pre-Tax Active Return

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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On September 30, 2018, the average stock volatility forecast by the Barra US Total Market Equity (USSLOW) model was 42.29% per year in the small-cap Russell 2000 Index but only 25.48% per year in the large-cap Russell 1000 Index.
2 According to FTSE Russell, the annual percentage turnover in the small-cap Russell 2000 averaged 29.8% between 1995 and 2005, and 12.1% between 2006 and 2017. State Street Global Advisors reports that turnover in the large-cap Russell 1000 has typically been below 4%.
3ATBAT is Aperio’s after-tax back-testing tool. By varying start date, ATBAT generates multiple runs of a tax-managed strategy at a fixed horizon. This provides us with ranges of realizations of return and risk, leading to a broad perspective on strategy performance.

The Russell 1000® Index is an equity benchmark for US stock performance. It is a capitalization-weighted index covering the largest 1,000 publicly traded US stocks.
The Russell 2000® Index is an equity benchmark for US stock performance. It is a capitalization-weighted index covering approximately 2,000 publicly traded small-cap US stocks in the Russell 3000® Index.
Aperio's strategies are not in any way connected to or sponsored, endorsed, sold, or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). All rights in the Russell indexes vest in the relevant LSE Group company. The LSE Group does not accept any liability whatsoever to any person arising out of the use of the strategies or the underlying data.

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