How to overcome the drag Hillary Clinton’s tax plan would create

When Republicans win the White House, tax rates normally hold or decrease, and conversely, when the Democrats hold the Oval Office, taxes are likely to increase. Below we examine the after-tax investment performance of the proposed Clinton plan, and evaluate the alpha that managers will need to overcome the increased tax drag that plan will create.
The Clinton proposal replaces the current rates and holding periods with seven new capital gains holding periods and a sliding tax-rate scale: assets held two to three years would be taxed at 39.8% and assets held three to four years would be taxed at 35.8%. The current long term tax rate of 23.8% would apply only for assets held longer than six years. Who knows if investors will stay the course for that long and forego other opportunities? What we do know is that creating after-tax wealth, what really matters for taxable investors, will require more diligence than ever.
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A study by Arnott, Berkin and Bouchey (2011) looked at the impact of turnover and taxes on compound growth. That study showed that most strategies don’t support the taxes incurred to generate their alpha. However, it made the simplifying assumption that all gains were taxed at a flat 35% rate.
We reworked the calculation to adjust for the two holding periods and difference in the applicable tax rates: 43.4% short-term rate for assets held less than one year and 23.8% long-term rate for those held greater than one year. The new results show a slight reduction in the alpha needed when the long-term gain rate is applied. Nonetheless, for an assumed 6% growth rate, a steady 1.65% alpha is needed to justify the taxes incurred with a modest 25% turnover. With higher turnover comes the need for more alpha. For example, turnover of 75% the annualized alpha needs to be 3.55% — a relatively ambitious goal for most active managers.
After incorporating the Clinton multi-holding period plan the hurdle becomes higher: In a 6% market environment the hurdle increases by 71 basis points (or 43%) for the 25% turnover regime. At 75% turnover, the alpha hurdle increases by 74 basis points of additional annual alpha.
While it is unknown what tax proposals, if any, will prevail, the likely measures will presumably include some tax reform, placing the value of tax-management strategies at a premium. Investors and advisers are well served to keep these points in mind:
1. Increased alpha needed to cover taxes and fees.
With an increase in tax rates, managers will need to be more conscious of the tax impact that comes with each trade and their overall level of turnover/realized gains.
2. Losses become increasingly valuable to investors.
Capital losses generated by selling a security at a price lower than its purchase price can be used to offset realized capital gains. However, balancing loss realization versus performance trade-offs, especially in volatile market environments, requires skill and experience.
3. Greater value of gain deferral.
One way to avoid paying capital gains taxes is to defer realizing gains. By holding underlying securities, and being aware of the gain attached to each position, the tax impact can be better managed by knowing what tax rate applies to each holding.
4. The holding period must be monitored.
Under the proposed Clinton plan, a manager must now monitor seven holding periods in determining which security to sell, with the tax rates gradually decreasing as the position ages. Managers should be able to offer clear guidelines on how this is incorporated into their process.
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With the possibility of higher tax rates and longer holding periods to qualify for long-term status, active managers will need to be more cognizant of the above four factors in order to maximize their investor’s after-tax wealth.
Bob Breshock is managing director, Jacob Greene is regional representative and Michael Kincheloe is quantitative analyst at Parametric Portfolio Associates.