A Framework for Minimizing the Tracking Error in an Indexed Portfolio Through Efficient Tax Management

Abstract

This paper presents a framework for an investor to minimize a loss function that includes the total costs from tracking errors, capital tax losses, and transaction costs. Using this framework, we analyze optimal trading decisions and suggest a trading rule called the “x-percent rule,” which minimizes the loss function. According to this trading rule, once the price of a stock position in the portfolio drops x percent from its purchase price, the portfolio manager sells that position and reinvests in another stock from the same sector. Numerically, the proposed framework is applied to simulated asset returns based on parameters calibrated from historical U.S. stock market returns.