Heuristic Portfolio Trading Rules with Capital Gain Taxes

Marcel Fischer, Michael F. Gallmeyer
2012 Social Science Research Network  
Heuristic Portfolio Trading Rules with Capital Gain Taxes This paper studies the out-of-sample performance of portfolio trading strategies when an investor faces capital gain taxation and proportional transaction costs. Under no capital gain taxation and no transaction costs, we show that, consistent with past literature such as DeMiguel, Garlappi, and Uppal (2009b), a simple 1/N trading strategy is not dominated out-of-sample by a variety of optimizing trading strategies. A notable exception
more » ... notable exception of a strategy that does outperform 1/N in our analysis is the parametric portfolios of Brandt, Santa-Clara, and Valkanov (2009). With dividend and realization-based capital gain taxes, the welfare costs of the taxes are large with the cost being as large as 30% of wealth in some cases. Overlaying simple tax trading heuristics on these trading strategies improves out-of-sample performance. In particular, the 1/N trading strategy's welfare gains improve when a variety of tax trading heuristics are also imposed. For medium to large transaction costs, no trading strategy can outperform a 1/N trading strategy augmented with a tax heuristic, not even the most tax-and transaction cost ecient buy-and-hold strategy. Our results thus show that optimal trading strategies trade risk and return considerations o against tax considerations and neither solely focus on any of the two.
doi:10.2139/ssrn.2172396 fatcat:7usutgvtmfel3h5hfptmr57psq