Investors are currently facing the fourth most volatile period in stock market history and the most volatile market since the 1938 depression. What's more, we are evidently in a recession.

In such conditions, alpha—the improvement of absolute returns—is difficult to come by. Yet the current market is actually the best in the past 20 years for capturing alpha—tax alpha, that is.

Alpha represents a portfolio's total return over and above a given benchmark, such as the S&P 500. Tax alpha is the improvement of portfolio returns created by sound tax management: strategically harvesting stock losses for tax deductions by selling depreciated stocks at opportunities as they occur.

Losses can be used to offset capital gains, ultimately generating tax alpha. Too often, portfolio managers focus on year-end tax-loss harvesting.

This approach is only effective if there are actual losses in a given year as of December. But because of positive calendar-year equity returns, opportunities to harvest losses in December in recent years have been few and far between. As a result, these managers fail to get deductions for their clients.

Year-Round Strategy

A better tax-management strategy centers on continuously harvesting losses as they occur year-round rather than waiting until December to see if there's an opportunity. Each market shift presents potential opportunities to take deductions on losses that can be used to offset taxes on any gains.

A review of the performance of the Dow Jones Industrial Average shows that there were many opportunities to capture losses throughout each of the last three calendar years. (See "Harvesting Year-Round.")

When trading for tax alpha, the strategy is able to consider a seemingly infinite number of variables and stocks using a quantitative tool first conceived and used by CalPERS over 30 years ago. Managers have the ability to consider correlations between stocks in the existing and target portfolios, transaction costs, risk characteristics and the implications of each potential trade combination.

Another overlooked area in the quest for tax alpha is transition costs, which are defined as the costs of getting out of one stock and into another. These include trading and management costs.

Tax-harvesting and transition-cost strategies can be effectively dovetailed within a comprehensive overlay strategy that assesses existing portfolios against model portfolios to produce target portfolios. This method is known as an overlay strategy because client portfolios are digitally overlain with target portfolios and analyzed using a quantitative tool to identify potential trades that maximize opportunities for taking deductions on losses. At the same time, this methodology focuses on replacing these stocks with suitable candidates that are consistent with other portfolio management goals‹assuming transition costs aren't prohibitively high.

The ideal result, known as the target portfolio, would be one as fully diversified as the original client portfolio. And it would have more potential for alpha, made possible in part by tax alpha yielded by the deductions from losses.

Overlay Tools

Tax alpha and transition costs are important variables, but they shouldn't be considered in isolation. Instead, they should be part of a larger overlay methodology that considers myriad variables.

These overlay methodologies are powered by specialized software that compares and contrasts key aspects of stocks in the client and model portfolios. (Portfolio managers can purchase specialized investment managers' models at a fraction of the price of a typical separate-account relationship.) Before liquidating stocks in the existing portfolio, overlay managers use data analysis to consider any market correlations between stocks in the two portfolios. They also consider the tax implications of tens of thousands of potential trading combinations.

For example, assume that a client portfolio owns Exxon and has registered a significant gain in the stock. The model portfolio owns BP. If the manager sold the position in Exxon to match the model, then the manager would essentially be letting go of a large global oil and gas company and replacing it with another large global oil and gas company.

In this case, selling would generate negative tax alpha. These trades would result in no diversification whatsoever. Once taxes are taken into account, it becomes clear that substituting one for the other is too costly. The two securities are highly correlated and hence, at least in theory, will perform quite similarly. When trading, the tax manager should hold the position in Exxon and sell other securities that have a lower correlation to the model's holdings, thus producing a lower tax burden.

By holding the position, the manager is minimizing the transaction costs by not making an unnecessary trade. The risk is comparable, and the correlation is quite high, making it wise to retain this position in the new hybrid portfolio.