Most investment returns are measured before taxes. While this is an important starting point, it may be an incomplete picture of your true returns if your investments are held in a taxable account. For a more precise view of investment returns, calculating the tax alpha can be invaluable.

Tax alpha is an investment portfolio management concept that refers to the additional value generated by implementing tax-efficient strategies. This article explores the definition of tax alpha, strategies to achieve it, and the role advisors can play in improving tax efficiency for clients.

Key takeaways:

• Tax alpha considers how an investment performed relative to its benchmark on a pre-tax and after-tax basis.
• There are several tax-efficient techniques advisors can implement via direct indexing strategies to help clients achieve tax alpha, including tax loss harvesting and avoiding or delaying capital gains taxes.

What is tax alpha?

Investors are probably familiar with the term “alpha” to describe the difference in performance relative to a benchmark. If an investment has a 10% return while its benchmark has a 9% return, the investment would be considered to have a 1% alpha. While simply referred to as alpha, this is technically pretax alpha.

For taxable accounts, what ultimately matters is the after-tax return, or the return the investor gets to keep after deducting taxes on capital gains, dividends, and interest. Tax alpha seeks to take advantage of the benefits of tax management by considering how an investment performed relative to its benchmark on both a pretax and after-tax basis.

Positive alpha suggests greater value in reducing taxes, whereas negative values suggest higher taxes may lower returns. Zero suggests passive (or no) tax-management techniques were used. Tax alpha is typically negative for most investment strategies unless they specifically use active tax-management techniques (see tax loss harvesting below).

How to calculate tax alpha

To calculate tax alpha, start by determining how the investment did relative to its benchmark on a pretax basis (pretax alpha). Next, determine how the investment did relative to its benchmark on an after-tax basis (after-tax alpha).

Both the investment and index’s returns need to be attributed to unrealized gains and losses, realized gains and losses, interest, and dividends. For realized gains and losses, the hold period needs to be assigned to short term and long term. For dividends received, they need to be classified into qualified and nonqualified.

How direct indexing may enhance tax alpha

Direct indexing strategies are designed to match an index’s pretax return by owning stocks in a separately managed account (SMA). Using a technique known as tax loss harvesting, the direct indexing manager watches the account for losses to harvest and systematically sells stocks that are down to lock in the tax losses and then replaces them with another index holding they don’t own.  

This negative tax loss when subtracted from pretax returns results in higher after-tax returns, which often leads to positive tax alpha for strategies that actively use tax loss harvesting. By comparison, mutual funds and exchange-traded funds (ETFs) cannot pass through any losses, only gains, which makes them less tax efficient and more likely to have negative tax alpha.

Techniques advisors can use to help clients achieve tax alpha

Financial advisors can be invaluable to investors as they construct portfolios designed to outperform on an after-tax basis. There are several tax-efficient techniques that can boost after-tax returns, such as tax loss harvesting and deferring payment of capital gains.

How tax loss harvesting works
Tax loss harvesting involves selling securities at a loss to offset capital gains and reduce tax liabilities. This strategy allows investors to minimize their taxable income by realizing losses on investments that have declined in value. By systematically harvesting losses throughout the year, investors can continually offset gains and reduce their overall tax burden.

Using harvested tax losses to create tax alpha

Direct indexing investing strategies

Direct indexing can play a valuable role in a tax-efficient investment strategy, especially for high-net-worth investors. Let us help you create portfolios that put taxes first.