Having Your Cake and Eating It Too: The Before- and After-Tax Efficiencies of an Extended Equity Mandate

This article shows that extended mandates are especially effective for investors subject to taxes. Not only is the portfolio more efficiently positioned from a before-tax perspective, but it also offers significant after-tax benefits from both increased loss harvesting and tax arbitrage between tax rates on long and short positions.Recent studies have shown that adding a short extension to a long-only tax-exempt equity portfolio leads to a more efficient portfolio. In this article, we show that these extended mandates are even more effective for taxable investors. Not only is the portfolio more efficiently positioned from a pretax perspective, but it also offers significant after-tax benefits from increased loss-harvesting opportunities and tax arbitrage between tax rates on long and short positions.Following a review of extended strategies, the principles of tax-efficient investing, and the relevant tax regulations for long and short holdings, we give a conceptual rationale of why this strategy works so well for taxable investors. One reason is that a portfolio with long and short positions offers loss-harvesting opportunities in both up and down markets, in contrast to a long-only portfolio, which suffers from a lock-in effect during bull markets. Extended mandates also offer an effective arbitrage on differential tax rates because both realized losses and the expensing of dividends on the short side are always at short-term rates. A short extension thus allows holdings to be repositioned in a more tax-efficient manner, which creates a more optimal portfolio from a pretax perspective and reduces taxes from both inside and outside the portfolio.To explore our conceptual expectations and provide empirical support, we ran a series of Monte Carlo simulations based on 25 years of actual S&P 500 Index returns. We constructed forecasts with a moderate amount of explanatory power by using realized returns mixed with a significant amount of noise; we also constructed monthly risk-controlled portfolios for both long-only and short-extension strategies that were managed in both a tax-exempt and a tax-efficient manner. We examined returns and their components on a before- and after-tax basis.Our simulation results confirm our expectations. If run in a tax-insensitive fashion, the tax-exempt long-only case has a positive added value that becomes negative after taxes, but it retains a significant amount of added value when run with proper tax management. The tax-exempt extended mandate improves upon the long-only case. These results confirm and enhance prior research. The after-tax results of extended mandates are particularly new and interesting. Even when run in a tax-insensitive fashion, the extended strategy retains positive after-tax performance because of realized losses from short positions sold in a generally rising market. The real power arises when short-extension portfolios are run in a tax-sensitive manner, with annualized after-tax alpha more than double that in the long-only case. To gain further insight into the dynamics of these strategies, we examined their performance and characteristics over time and analyzed the components of after-tax value performance. Both tax-advantaged strategies notably reduce gains realization, but extended mandates have a superior dividend advantage and dramatically increase the capture of short-term losses.We close with some practical considerations. We discuss the impact of different tax rates, both individual and corporate. We also discuss the impact of forecasting skill because we assumed a respectable amount thereof in our simulations. Although pretax added value is one aspect of added value, the after-tax aspect is far larger and far more certain. Finally, adding a short extension is particularly useful for legacy assets with a low cost basis because the extra extension can reposition the portfolio and the additional loss harvesting allows large positions to be reduced in a tax-efficient manner. For taxable investors, the case for extended mandates is quite compelling.