Direct indexing is an excellent tool for improving after-tax returns for taxable clients. However, the predominant approach to doing this, where tracking error is minimized and any possible tax benefit is constrained, may be sub-optimal. Focusing too much on tracking error can lead to missed opportunities to add after-tax value. The best outcome for clients is to maximize their after-tax return/wealth, which may require taking on higher levels of tracking error. Based on 20 years of simulated portfolios, the authors found that higher active risk can potentially provide more tax alpha without sacrificing pre-tax performance, and that it is most beneficial in years with large drawdowns and during the earliest years after inception. When investors choose direct indexing providers, it is important to take a holistic view of their risk tolerance and investment horizon, and of the providers’ investment process—particularly how loss harvesting is implemented, how risk is managed, and how the strategy performs during large drawdowns. TOPICS: Mutual funds/passive investing/indexing, wealth management, portfolio construction, performance measurement Key Findings ▪ Systematic tax loss harvesting contributes significantly to clients’ after-tax wealth without compromising pre-tax performance. Tax alpha is often highest during the early years after inception, stabilizes as portfolios mature, and persists over an extended period of time. ▪ Higher active risk provides more opportunities to harvest losses. The value-add is usually greatest in years with large drawdowns and at the earliest stage of portfolios, when higher active risk is permitted. ▪ Tax managed portfolios tend to tilt positively to momentum and growth factors, and negatively to size, value, and dividend yield factors. The magnitude of active factor exposure is modest, however, and often not of real concern.
We examine the performance characteristics of recently introduced thematic indices using standard asset pricing theory. We find that thematic indices generally have strong negative exposures towards the profitability and value factors, indicating that they hold growth stocks that invest now for future profitability. As such, investors in thematic indices are effectively trading against quant investors, who prefer stocks that are currently cheap and profitable. From an asset pricing perspective, the negative factor exposures of thematic indices imply low expected returns. As there is clearly a clientele for thematic indices, we discuss how investing in these strategies may be rationalized despite their unfavorable factor exposures.
This works focuses on the challenges posed by benchmarking private equity performance and the solutions that have evolved in practice. The paper puts the practical approaches used by investors into four general categories, and describes the relevant characteristics that distinguish each category, the typical circumstances in which they normally arise, and the areas in which each presents opportunities for improvement. The authors’ perspective is neutral as to which method is preferred or superior, recognizing that each one presents particular advantages and challenges. The intent is to demonstrate the relationship among the different approaches that eventually should rest on similar underlying principles of objectivity, efficiency, and transparency. The intended audience includes institutional asset owners with significant allocations to private equity, that need to adequately measure the value added to their portfolio by direct and fund investment, as well as investment managers who need to track how the performance of their strategies and implementations compares to that of their peers. TOPICS: Private equity, performance measurement Key Findings ▪ Analyze the ways the investment industry has evolved to tackle the challenges with private equity benchmarking in practice. ▪ Reduce the reliance on subjective measures like appraisal values and heuristic groupings, and focus on objective measures like cash flows, transacted values, and efficient benchmark portfolios. ▪ Evolve beyond static measures of performance to those that suggest the confidence intervals that differentiate between skill and luck.
Investments aligned with environmental, social, and governance (ESG) principles are rapidly growing globally. In the exchange traded fund (ETF) industry, this gives rise to the power of ESG rating firms that have the influence to direct capital flows into ETFs tracking the indexes. This article examines the issues of substantial ESG rating divergence across rating firms, the impact on investors’ choices, and the influence on the ETF industry. The divergence appears to be the greatest in social and governance components, and is often qualitative in nature. The author found that certain economic sectors are more prone to ESG rating divergence than others. She presents a case study about two ESG ETFs that are viewed quite differently under various rating lenses, and offers suggestions to investors, advisors, and analysts on how to research ESG ETFs, given the major rating divergence. The article concludes with ways the ETF industry could improve its practices collectively to better serve investors with clarity and to sustain the growth of ESG impact investments.
This study aims to shed light on a freely published mutual fund screening tool—the capture ratio—and its ability to predict future fund performance (i.e., alpha). This analysis is of interest for both financial advisors and retail investors who deploy mutual fund screening tools. We find that capture ratios measured over shorter periods, such as one year, do not exhibit subsequent performance predictability. Conversely, we find that the three-year and five-year capture ratios are useful for investors in the full sample. However, analysis across cap and style-based fund subsamples shows that this return predictability is most consistent in predicting three- and five-year performance. TOPICS: Mutual funds/passive investing/indexing, performance measurement Key Findings ▪ Capture ratios measured over one year are unreliable in predicting mutual fund performance. ▪ Capture ratios measured over three and five years exhibit consistent performance predictability across cap and style fund subsamples. ▪ Mutual fund investors exhibit a real return-chasing behavior as it relates to capture ratios.
