Tax-Smart Portfolio Valuation and Performance Measurement

Abstract

The reported performance of a portfolio is consequential for both investors and managers. One component of the return calculation is the beginning and ending value of the portfolio. The standard in the industry is to calculate portfolio values from the market prices of the constituent securities. Assuming the portfolio can be liquidated at these prices, in the absence of tax considerations, the market value accurately represents the true value of the portfolio, and therefore, the resulting measure of performance is uncontroversial. But what if the portfolio is taxable? Neither the market value nor the liquidation value accurately represents the true worth of a taxable portfolio. However, accurate values are essential to calculating the performance of mutual funds, exchange-traded funds, and separately managed accounts. This is especially true for tax-exempt municipal bond portfolios—interest is tax-free, but capital gains are taxable. The author explores three alternatives to pretax value: liquidation value, hold value, and the larger of these two, defined as tax-smart value. The author recommends the tax-smart value to measure the performance of an actively managed portfolio.

TOPICS: Portfolio construction, legal/regulatory/public policy, mutual funds/passive investing/indexing, fixed income and structured finance

Key Findings

• ▪ Pretax portfolio value is inappropriate for measuring the true performance of a taxable portfolio.

• ▪ For actively managed portfolios, we recommend using tax-smart value, which is the greater of after-tax liquidation value and hold value.

• ▪ For buy-and-hold portfolios, hold value is recommended.

• ▪ The calculation of the hold value of a tax-exempt bond requires tax-neutral option-adjusted spread analytics.