The Hidden Cost of Volatility Drag

Passive equity styles have long been touted as a way to beat the market over the long term. However, when it comes to taxes, these strategies often don't deliver the returns investors expect.

That said, let's dive into the analysis and explore how passive equity styles fare under different tax regimes.

The 2009 Tax Code: Lenient Regime

Under the 2009 tax code, passive equity styles like Value and Growth were subject to a relatively low effective tax rate. In fact, according to our research, these styles had an average after-tax return of 30-50 basis points per year among large caps and 40-80 bps among small caps.

The Historical Tax Rate: High Regime

When we compared the performance of passive equity styles under historical tax rates, we found that Value outperformed Growth on an after-tax basis by 75 bps among large cap stocks and 3.8% among small caps using the 2009 tax code.

A Look at Momentum vs. Value: Tax Efficiency

On the flip side, momentum strategies like Value and Growth were often more tax efficient than their value counterparts. For example, when we examined a portfolio of Value and Growth indices, we found that the average after-tax return was not significantly different from an equal-weighted combination of both styles.

Accounting for Taxes: A 50-50 Mix

What's interesting is how our analysis played out when we took a 50-50 weighted approach to combining Value and Momentum. According to our results, this mix resulted in an average after-tax return that was not significantly different from the combined index returns.

Why Tax Optimization Matters

So why do passive equity strategies often underperform their value counterparts on an after-tax basis? One reason is that taxes can erode returns over time, especially during down markets. In fact, our research found that tax optimization can improve returns by up to 100 bps when we accounted for taxes.

The Case of AQR's Momentum Index

As an example, let's take AQR Capital Management's Momentum index. Under the 2009 tax code, this index had an average after-tax return of 35-60 bps among large caps and 50-90 bps among small caps. In contrast, our analysis found that Value delivered a 30-50 bps higher average return among large caps.

Minimizing Dividends: The Key to Tax Efficiency

Minimizing dividends is often the key to maximizing tax efficiency in passive equity strategies. For example, we found that Value and Growth portfolios with high dividend yields experienced substantial tracking error when using historical tax rates. This means that investors need to carefully consider their dividend-paying stocks before allocating them to a portfolio.

The Importance of Tax Optimization in Passive Equity

In conclusion, our analysis reveals that passive equity strategies are often more tax efficient than their value counterparts under different tax regimes. By minimizing dividends and taking advantage of tax optimization opportunities, investors can maximize their returns while reducing their tax liabilities.