Eugene Fama Jr.

The Error Term

Both cases have the same factor exposures and the same expected returns as the market. Cases 1 and 2, however, have significantly higher after-tax expected returns, especially in periods where dividend yields are high. In 1991, for instance, simulated Case 1 would have saved 0.87% in taxable dividends and simulated Case 2 would have saved 2.00% in taxable dividends. The contribution from tax management is expected to be positive regardless of the direction or magnitude of the investment return. The resulting increase in after-tax compound return is simulated in Exhibit 4.

When investing in tax-efficient strategies, investors make an implicit trade-off between tracking benchmarks and managing dividends. Structuring a diversified portfolio according to expectations and preference requires us to acknowledge and try to understand these trade-offs. This is easier when we recognize that benchmarks and published indexes are fundamentally arbitrary. They experience random noise in their returns just like managed portfolios do. Many investors will want to tolerate this noise in exchange for portfolio engineering and tax structure.

As always, the multifactor model helps us frame the problem. It helps us target factor exposures rather than benchmarks and helps us distinguish systematic expected returns from random noise. Most of all, it gives us the tools to build focused portfolios and the perspective to stay disciplined during times when performance differs from the long-term expectation.

This article owes a huge debt to discussions with Dave Butler and especially Eduardo Repetto, who provided the data and lots of guidance.

December 2001