Handbook of Finance: Investment Management and Financial Management

Chapter 13. Investment Management for Taxable Investors

DAVID M. STEIN, PhD

Managing Director, Parametric Portfolio Associates

JAMES P. GARLAND, CFA

President, The Jeffrey Company

Abstract: Much of the practice of investment management has evolved to suit the needs of tax-exempt institutional pension funds. There is an increasing realization, however, that many practices suitable for tax-exempt investing need to be modified for taxable investing. Taxes matter a great deal. Taxes represent a very large performance drag, often larger than transaction costs, management fees, or inflation. The popular sentiment is that investors should not allow their investment decisions to be dominated by tax considerations. While it is true that tax considerations should not dominate investment decisions, tax considerations do significantly influence investment returns, and investors would be well advised to consider taxes in their investment decisions. Failing to do so can be expensive, particularly if investors allow taxes to erode their returns over the long term.

Keywords: capital gains, after-tax performance measurement, performance benchmarking, after-tax risk, after-tax asset allocation, tax-efficient investing, active tax management

Taxes complicate decision making in many ways. Here are a few key examples:

• Asset allocation, one of the most important investment decisions, is complicated not only by the particular tax rates that investors face, but also by their investment horizons and by the unrealized ...