Heuristic Portfolio Trading Rules with Capital Gain Taxes

We study 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 DeMiguel, Garlappi, and Uppal (2009), a simple 1/N trading strategy is not dominated out-of-sample by a variety of optimizing trading strategies, except 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 efficient buy-and-hold strategy. Overall, the best strategy is 1/N augmented with a heuristic that allows for a fixed deviation in absolute portfolio weights. Our results show that the best trading strategies trade diversification considerations off against tax considerations without solely focusing on one or the other.