Momentum Stocks Lead in Tax-Efficient Equity Styles

The Hidden Impact of Taxes on Passive Equity Styles

Tax efficiency is a critical yet often overlooked factor in constructing successful investment portfolios. The impact of taxes can significantly alter the net returns of various investment styles, potentially leading to vastly different outcomes for taxable and non-taxable investors. This comprehensive analysis delves into how passive equity styles fare in terms of tax efficiency.

Tax Efficiency: A Crucial Factor in Equity Styles

Tax efficiency refers to an investment's ability to minimize tax liabilities while generating returns. For taxable investors, understanding the after-tax performance and tax efficiency of various equity styles is essential for making informed asset allocation decisions. After-tax returns, rather than pre-tax returns, are the critical input in this process.

This analysis focuses on long-only equity style portfolios based on size, value, growth, and momentum. These styles are commonly used in both academia and practice. The study examines "real world" or investable indices from July 1974 to June 2010, such as Russell 1000 and Russell 2000 Core, value and growth indices, and AQR Capital Management’s U.S. large and small capitalization momentum indices.

Momentum Tops the Charts in After-Tax Performance

When accounting for taxes (gross of transactions costs), momentum delivers the highest average returns among the styles. Specifically:

- Among large caps, momentum outperforms value by 8 (12) basis points per year using the 2011 (historical) tax rates and outperforms growth by 217 (119) bps per year. - Among small caps, momentum outperforms value by 95 (65) bps per year and outperforms growth by 402 (294) bps per year using the 2011 (historical) tax rates. - Value outperforms growth on an after-tax basis by 208 (107) bps among large caps and by 307 (229) bps per year among small caps using the 2011 (historical) tax rates.

However, even though momentum and value face the highest effective tax rates as stand-alone investments, their outperformance relative to growth and the market survives but shrinks, particularly under more punitive tax regimes.

Value and Momentum Face Similar Tax Rates for Different Reasons

Despite having five to ten times the turnover of value, momentum faces a similar tax rate (slightly higher) because it generates a great deal of short-term losses which offset many of its capital gains. Value, on the other hand, generates significant dividend income, which is very tax inefficient.

The effective tax rates of these styles change significantly when viewed within the context of a broader asset allocation framework and in down markets. This underscores the importance of considering taxes in portfolio construction to maximize after-tax returns for taxable investors.