RT Journal Article
SR Electronic
T1 Taxation Without Replication
JF The Journal of Portfolio Management
FD Institutional Investor Journals
SP 73
OP 83
DO 10.3905/jpm.2007.698036
VO 34
IS 1
A1 Don M. Chance
YR 2007
UL https://pm-research.com/content/34/1/73.abstract
AB It is well known that investors can structure derivatives portfolios to replicate a position in an underlying asset and synthetically create an index fund. While an individual investor can achieve perfect replication on a before-tax basis, taxes make derivatives inferior to direct investment in the index, because synthetically generated dividends and capital gains do not benefit from the preferential tax treatment accorded direct investment in the index. Derivative strategies also have lower after-tax expected returns and Sharpe ratios and are less volatile than the index. Option strategies benefit from a tax inequity favoring low exercise prices but are still inferior to direct investment in the index. Thus, synthetic indexing may be effective on a before-tax or non-taxable basis, but it fails for taxable individual investors because today's tax code disadvantages derivatives replicating strategies.TOPICS: Derivatives, mutual funds/passive investing/indexing, portfolio construction