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Tax-Aware
Investment฀Management
THE฀ESSENTIAL฀GUIDE
Douglas฀S.฀Rogers
BLOOMBERG฀PRESS
n e w ฀ y o r k
© 2006 by Douglas S. Rogers. All rights reserved. Protected under the Berne Convention.
Printed in the United States of America. No part of this book may be reproduced, stored
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First฀edition฀published฀2006
1฀3฀5฀7฀9฀10฀8฀6฀4฀2
Library฀of฀Congress฀Cataloging-in-Publication฀Data
Rogers,฀Douglas฀S.
฀ Tax-aware฀investment฀management฀:฀the฀essential฀guide฀฀/฀฀Douglas฀S.฀Rogers.
฀ ฀ ฀ p.฀cm.
฀ Summary:฀“Illustrates฀how฀investment฀strategies฀for฀tax-exempt฀accounts฀don’t฀work฀for฀individuals฀
subject฀to฀taxes.฀Offers฀techniques฀for฀comparing฀tax-efficiency฀of฀mutual฀funds,฀hedge฀funds,฀and฀
investment฀managers,฀and฀presents฀more-sophisticated฀strategies฀for฀offsetting฀gains฀against฀losses฀in฀
wealth฀planning,฀portfolio฀management,฀and฀estate฀planning.฀Includes฀results฀of฀historical฀research,฀
100฀tables฀and฀charts”--Provided฀by฀publisher.
฀ Includes฀bibliographical฀references฀and฀index.
฀ ISBN฀1-57660-180-3฀(alk฀paper)
฀฀1.฀฀Investments--Taxation--United฀States--Handbooks,฀manuals,฀etc.฀฀2.฀฀Portfolio฀management--
Handbooks,฀manuals,฀etc.฀฀I.฀฀Title.
฀ HG4910.R655฀2006
฀ 332.6--dc22฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀฀2005030613
฀
C O N T E N T S
฀
฀ ฀Acknowledgments
฀................................................................ vii
฀
฀ ฀Introduction
฀........................................................................ ix
PART
฀
ONE
฀|฀฀
EVOLUTION
฀
OF
฀
KNOWLEDGE
฀฀
PERTAINING
฀
TO
฀
TAX
-
AWARE
฀
INVESTMENT
฀
MANAGEMENT
฀
1
฀ 1
฀ ฀The฀Evolution฀of฀Tax-Aware฀Investment฀Management
฀....... 3
฀
2
฀ The฀Sources฀and฀Impact฀of฀Taxes฀on฀
฀ ฀ Investment฀Returns
฀........................................................... 11฀
฀
3
฀ Seminal฀Research
฀.............................................................. 21
฀
4
฀ The฀Tax-Aware฀Practitioner
฀.............................................. 33
฀
5
฀ ฀฀Creating฀the฀Triumvirate฀of฀Qualified฀
฀ Professionals
฀..................................................................... 45฀
PART
฀
TWO
฀|฀฀
AFTER
-
TAX
฀
REPORTING
฀
AND
฀
MEASURES
฀
OF
฀
TAX
฀
EFFICIENCY
฀
55
฀
6
฀ Mutual฀Fund฀After-Tax฀Reporting
฀.................................... 57
฀
7
฀ Separate฀Account฀After-Tax฀Reporting
฀............................. 77฀
฀
8
฀ Measures฀of฀Tax฀Efficiency
฀................................................ 95฀
PART
฀
THREE
฀|฀฀
TAX
-
AWARE
฀
PORTFOLIO
฀
MANAGEMENT
฀
101
฀
9
฀ Outperforming฀the฀Index฀Fund
฀...................................... 103฀
10
฀฀ ฀฀Quantitative฀Tax-Aware฀Portfolio฀Management
฀฀
฀
and฀Concentrated฀Stock
฀.................................................. 117฀
11
฀ Practices฀of฀Elite฀Tax-Aware฀Equity฀Active฀Managers
฀..... 133฀
12฀
฀฀Practices฀of฀Elite฀Tax-Aware฀Fixed฀Income฀฀
฀Active฀Managers
฀.............................................................. 149฀
13฀
฀The฀Hedge฀Fund฀Dilemma
฀............................................. 167฀
14
฀฀Amending฀the฀Search฀Process฀for฀Tax-Aware฀฀
฀ ฀Manager฀Selection
฀........................................................... 175
PART
฀
FOUR
฀|฀฀
CHALLENGING
฀
TRADITIONAL
฀฀
ASSET
฀
ALLOCATION
฀
METHODS
฀
189
15
฀฀Challenges฀With฀Traditional฀Investment฀฀
฀ ฀Policy฀Development
฀........................................................ 191
16
฀฀Developing฀After-Tax฀Asset฀Class฀Assumptions
฀.............. 209
17
฀฀Why฀the฀Style฀Box฀Hurts฀Taxable฀Investors
฀.................... 225
18
฀฀Positioning฀Assets฀by฀the฀Tax฀Characteristics฀฀
฀ ฀of฀the฀Entity
฀.................................................................... 243
19
฀฀฀The฀Role฀of฀Systems฀Solutions฀in฀฀
฀Tax-Aware฀Investing
฀........................................................ 271
Summary
฀...............................................................................
281
Appendix
฀................................................................................
283
฀
฀฀฀฀฀฀฀Continuing฀Education฀Exam
฀............................................
287
Index
฀.....................................................................................
294
A C K N O W L E D G M E N T S
Tax-Aware฀Investment฀Management:฀The฀Essential฀Guide
฀embodies฀the฀col-
lective฀wisdom฀of฀many฀people฀with฀whom฀I฀have฀been฀fortunate฀enough฀
to฀interact฀during฀my฀investment฀career.฀I฀want฀to฀acknowledge฀those฀who฀
have฀supported฀my฀efforts฀and฀provided฀me฀many฀of฀the฀insights฀neces-
sary฀to฀complete฀this฀work.฀I฀apologize฀to฀anyone฀I฀may฀have฀inadvertently฀
missed฀in฀my฀attempt฀to฀give฀credit฀where฀it฀is฀due.
I฀extend฀my฀gratitude฀to฀Ralph฀Rittenour฀Jr.,฀to฀Jeffrey฀Grubb,฀and฀to฀
my฀other฀associates฀at฀CTC฀Consulting฀for฀their฀backing฀of฀this฀project.฀
I฀am฀especially฀mindful฀of฀the฀support฀of฀Don฀Lindow฀and฀Chris฀Arvani฀
who฀recognized฀early฀on฀in฀my฀career฀my฀desire฀to฀take฀on฀new฀and฀ex-
citing฀research฀pertaining฀to฀the฀nuclear฀decommissioning฀trust฀(NDT)฀
industry.฀My฀participation฀at฀NDT฀conferences฀and฀my฀interaction฀with฀
Arland฀Brusven,฀David฀Krause,฀James฀Meehan,฀Joanne฀Howard,฀Mary฀Jo฀
Dempsey,฀Thomas฀Tuschen,฀Eric฀Knause,฀Mary฀Miller,฀and฀others฀only฀
heightened฀my฀enthusiasm.฀Michael฀Brilley฀and฀Gene฀Sit฀encouraged฀me฀
to฀submit฀my฀first฀article฀for฀publication฀on฀tax-aware฀investment฀manage-
ment,฀which฀set฀the฀stage฀for฀other฀projects฀to฀follow.฀Similar฀appreciation฀
is฀extended฀to฀Louise฀Wasso-Jonikas฀and฀Michael฀Radford฀for฀encouraging฀
my฀involvement฀in฀CFA฀Institute฀(formerly฀AIMR)฀activities฀and฀public฀
speaking.฀
Lee฀Price฀has฀always฀been฀a฀respected฀mentor,฀and฀to฀serve฀with฀him฀on฀
both฀AIMR฀Subcommittees฀on฀After-Tax฀Reporting฀has฀been฀an฀honor฀and฀
privilege.฀I฀will฀always฀be฀indebted฀to฀the฀members฀of฀the฀Subcommittee.฀
Their฀response฀to฀the฀SEC฀proposal฀for฀after-tax฀returns฀on฀mutual฀funds฀
and฀recommended฀revisions฀to฀the฀existing฀standards฀would฀not฀have฀been฀
possible฀without฀the฀assistance฀of฀Pauline฀Pilate฀and฀Alecia฀Licata.฀Stanley฀
Lee฀and฀Liz฀Miller฀of฀the฀New฀York฀Society฀of฀Security฀Analysts฀have฀been฀
consistent฀supporters฀of฀this฀topic฀and฀related฀issues.฀
I฀am฀truly฀thankful฀for฀the฀willingness฀of฀Tad฀Jeffrey,฀James฀Garland,฀
Robert฀Arnott,฀Joel฀Dickson,฀Jack฀Bogle,฀Peter฀Bernstein,฀Marc฀Moulton,฀
Brian฀Langstraat,฀David฀Stein,฀and฀Bob฀Breshock฀to฀share฀their฀expe-
riences฀on฀critical฀research฀and฀product฀development.฀Jay฀Whipple฀III,฀
Ron฀Surz,฀James฀Hollis,฀and฀Matt฀Schott฀have฀played฀critical฀roles฀in฀
furthering฀my฀understanding฀of฀systems฀technology.฀Robert฀Gordon฀and฀
vii
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