Tax Efficiency v Tax Optimality

Abstract

Strategies to efficiently manage the tax aspects of investing have been extensively researched and developed over the past several decades. In 1986 Joseph Stiglitz outlined a general set of principles of tax avoidance which focus on 1) postponement of capital gains 2) arbitrage between investors in different tax brackets or the same investor across time and 3) arbitrage between income, short term capital gains and long term capital gains. The application of these principles has generally led to 1) minimizing turnover, 2) deferring capital gains and 3) minimizing income. [Stiglitz, 1986]The field has evolved to equate low turnover with tax efficiency. The scope of this paper is to illustrate that high turnover strategies can be superior to low turnover strategies with taxes as a consideration in portfolio construction. Additionally, hedge funds for high net worth Individuals are typically unattractive after tax. Turnover is high, and the income is typically distributed through a K1 as income and not as a capital gain. The typical strategies to mitigate this are options overlays, or total return swaps both of which can be expensive. Simply shifting the hedge fund strategy to a separate account and actively distributing losses can eliminate the after tax headache many high net worth Individuals face when considering a hedge fund.