Hedge Fund Investing, Turnover, and Taxes

We’ve written before that turnover can sometimes get a bad rap. As we wrote in “The Sacrilegious Diaries: The Benefits of Turnover”:

‍“Stocks can move sharply higher or lower. Sometimes this happens without any news other than Mr. Market waking up to a thesis (or overreacting to the wrong one). When the price moves in this manner, it doesn’t change what the company is worth. Consequently, the security’s expected return changes. If the drop or increase in expected return is so pronounced that other, portfolio positions subsequently offer lower or higher expected returns, it is incumbent upon us to re-allocate that capital as nimbly and optimally as possible.”

In that piece, we suggested that transaction costs from this activity (e.g. commissions and bid-offer spreads) were indeed bad if they didn’t add value, but there were ways to decompose returns to analyze whether or not they did.

Moreover, we suggested that conventional wisdom about the perils of “trading” was in some ways based on an old narrative when everyone was paying ten cents a share to trade stocks, not the 1-2 basis points they are paying today. But as a manager of (mostly) institutional, non-taxable, capital (e.g. charitable foundations) we previously haven't discussed much on one thing which is extremely important to many family office and HNW investors.

Taxes.

And before moving on, let me state that the impact of taxes on net, post-tax, long-term equity returns can be massive. What drives it is the tax efficiency of holdings, whether or not the manager is able to generate excess returns, and – if so – what the source of those excess returns are.

I’ll get to how to analyze that in a minute. But in the meantime – for you US taxable investors in particular – here is a quick and dirty analysis of what is needed from “trading” in order to justify investing with a manager that turns his or her book over.

Here’s how we think about it.

Imagine a world where a manager – we will call him PM 1 - buys stocks and only sells them at the end of a five year holding period. At that point tax is realized at the LT cap gains rate of 20%, and tax is paid. An 8% annualized headline annual return works out to about 6.8% net after tax.

Now - for simplicity's sake - imagine the trader who is active, perhaps concentrated, and continuously managing a best ideas portfolio. Imagine that she has a culture where she is unanchored to the prices she paid for stocks and is driven entirely by forward-looking risk and reward, or when she likes to take advantage of market overreactions, sometimes on a short term basis. Let’s call her PM 2 – and let's imagine that every single penny of capital gains she ever produces will be taxable at the highest marginal ordinary tax rate of 37%.

In this extreme example, the question is this. How much more would PM 2 need to generate each year in order to justify an allocation to her instead of to PM 1?

We’ll, it depends.

It depends on how much return PM 1 actually generates. If PM 1 consistently generates annual returns of 2.5%, then PM 2 would need to outperform by just 0.7% each year to justify an investment.

However, the better that PM 1 performs, the higher that hurdle becomes for PM 2 to generate similar post-tax returns.

For example, if PM 1 were to generate 10% returns per year, PM 2 would need to outperform PM1 by 3.6% each year. Here’s a table showing the equalizing return streams at different return levels.

So, let’s say you’ve found the active manager who is likely to generate some sort of excess return over a buy and hold manager (or – for long-only products – perhaps over an index or an ETF), should you jump in?

Not yet!

There is an additional question, and this isn’t just a question that needs to be answered by taxable investors, this is one that needs to be answered by the managers themselves.

How do you make money?

Do your returns come from stock selection? Do they come from position sizing? Do they come from trading? How much of your return comes from each?

How about your excess returns? Do any come from your dynamic allocation? Do all of them?

Why are the excess returns important? Well, when it comes to allocating to a (hopefully) uncorrelated hedge fund manager, it’s the excess returns that investors want (and are happy to pay for). And it is the excess returns that inspired your hedge fund manager to get into the business in the first place.

Think of it this way. Imagine we did an analysis[i] showing that over 100% of the manager’s pre-tax returns were from stock selection, and that he gave back a little bit of alpha with poor position sizing, or perhaps panicky trading. Believe me, there are plenty of managers like that. But let’s say that those stock selection returns were so good that the manager still generated significant alpha. What should you do? What should he do?

Well, you should insist that that manager stops trading. Not only will his pre-tax returns increase, your post-tax returns will increase dramatically.  And he should agree!

But let’s say that the stock selection returns of your manager are decent, and uncorrelated to market returns, but they only get you slightly above flat (for a 0% net exposure hedge fund) or the market return (for a 100% net long-only fund); and furthermore let’s say that it is accurate position sizing and nimble trading that generates her noteworthy excess returns. This is a different scenario. What should you do? What should she do?

Well, you should tell her to stay the course, and as long as you believe she can generate the excess returns required (see the table above) over her peers (or diversified ETF, or whatever the benchmark) over the long run - and to be as smart as possible about maximizing holding periods (and minimizing tax) on the balance - it makes sense from a post-tax perspective to stay with her.

Tell her to stay as tax efficient as possible, but to keep on tradin’.

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