After-Tax Benchmarking: Developing an Industry Standard to Level the Playing Field

Tax alpha is defined as the difference between the after-tax excess return and the pre-tax excess return. The after-tax benchmark used for calculating the after-tax excess return, therefore, is critical to measuring tax alpha. Standardizing the methodology for calculating after-tax benchmarks promotes consistency, transparency, and comparability. To accurately measure an investment manager’s ability to add value on an after-tax basis, the benchmark used must reflect the following key drivers of after-tax performance: <list><list-item> ▪ Initial account funding (cash or in-kind securities) </list-item><list-item> ▪ Capital inflows and outflows </list-item><list-item> ▪ Capital gains and losses from outflows (short term and long term) </list-item><list-item> ▪ Rebalancing impacts of in-kind flows </list-item><list-item> ▪ Benchmark income (qualified and non-qualified) </list-item><list-item> ▪ Benchmark capital gain/loss realization/turnover </list-item><list-item> ▪ Federal tax rates (anticipated client rates or maximum federal rates) </list-item></list> The recommended approach to capture these factors is through a shadow benchmark. The article provides detailed guidance on building a shadow benchmark, including considerations for constituent-level versus total-level data, selecting a market index or proxy, and incorporating client portfolio events.