Taxes have a significant impact on the performance of any investment. Mutual funds and ETFs are required to distribute income and their realized capital gains to shareholders. Side Note – The tax efficiency of mutual funds vs ETFs is for another post. Tax burdens can be reduced by avoiding the realization of gains. Which brings us to the point of this post – the potential tax efficiency of momentum strategies. Keep in mind, this is not specific to any one particular strategy because there are different flavors of momentum…we are painting with a broad brush here.
Momentum strategies buy recent winners and sell recent losers. Which means, at each re-balance or evaluation, the holdings that have appreciated in value (gains) should stay in the portfolio while the holdings that have lost value (losses) could be sold. This leads to winners being held and losers being realized. This not only avoids the distribution of realized gains but gives a cushion of losses to help offset any gains that will be realized in the future. Both increase the potential tax efficiency of the strategy.
Higher turnover strategies (which MoMo would typically be classified as) usually translate into higher transaction costs and tax burdens. No argument for the transaction costs, but tax burdens should be further examined. Holdings winners and realizing losers is typical of momentum strategies and naturally lends itself toward tax efficiency. Not a topic often discussed about Momentum in general, but one worth noting.