Journal of Investment Strategies

Risk.net

Efficient trading in taxable portfolios

Sanjiv R. Das, Dennis Yi Ding, Vincent Newell and Daniel N. Ostrov

  • The paper develops an "optimization with simulation" methodology for tax effcient portfolio rebalancing over long horizons. while carrying the full cost basis, and considering cases when the investor is both alive or dead at the portfolio's horizon.
  • The approach resolves the "curse of dimensionality" that occurs in optimizing portfolio rebalancing when the full cost basis is carried as the state space grows uninhibitedly.
  • The portfolio rule develops an optimal no-rebalancing interval for the risky asset fraction in the portfolio, and optimality is more sensitive to the placement of this interval than its width. Static band rules are typically suboptimal.
  • The solution accounts for the two well-known options in portfolio rebalancing, the tax put and the tax reset option.
  • Counterintuitively, the taxable portfolio may hold more risky asset than a nontaxable portfolio. Also, as tax rates on gains increase, generally more, not less, is invested in the risky asset.
  • The 5/25 rebalancing rule is shown to be suboptimal. The authors extend the model to include transactions costs as well.

We determine life-cycle trading strategies for portfolios subject to the US tax system. Our method employs Monte Carlo optimization. It accommodates long horizons (between forty and sixty years) and large numbers of trading periods (eg, 480), while accounting for the full cost basis history of the portfolio’s stock holdings, thus sidestepping the curse of dimensionality. We present many new results that provide insights into questions about taxable portfolio investing which were previously unexplorable. Some of our results challenge current conventional wisdom. For instance, we establish circumstances where raising the allocation of stock is optimal though counterintuitive and demonstrate the suboptimality of the 5/25 rebalancing rule, even as a rule of thumb.

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