‘Tax alpha’ is much more than simple tax-efficiency


The basics of tax alpha call for tax-efficient investing at a minimum. While some funds may have a strong history of returns, they may have come at the expense of taxes, Steffen noted. You’ll have to dig a bit to understand what your net gain will be.

Exchange-traded funds “have become so popular, in part, because indexing is so tax-efficient, and the ETF structure makes the investment even more tax-efficient,” he said.

First, index funds keep turnover low because they only buy and sell securities when there’s a change in an index’s composition. By not engaging in rapid trading, there are no capital gains to realize. ETFs go one step further. They are not required to distribute what capital gains there are to shareholders, unlike mutual funds, which must.

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“There’s no question about it, ETFs have better tax efficiency than mutual funds,” said CPA and financial planner Theodore Sarenski, CEO and president of Blue Ocean Strategic Capital.

For investors who need even more tax alpha, separately managed accounts are able to fine-tune each investor’s tax liability while still being professionally managed. Instead of owning shares of a fund, SMA investors own their securities directly, even if they are replicating an index. That provides more flexibility. They can use any losses in the account to offset losses anywhere else in their portfolio, not just that particular strategy.

However, it’s not a given that SMAs are tax-efficient.

“The direct ownership can help you reduce taxes, but if the manager you use is a momentum investor where they’re trading all the time, there’s going to be tremendous turnover,” said Sarenski. “How tax-efficient is a manager like that going to be?”

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