Alpha Through an After-Tax Lens

Market cap-weighted indexes have been a high hurdle for active managers. From an after-tax lens perspective, capital gains distributions may create a second hurdle, as advisors seek to not only find alpha but help investors keep more of it. Wider dispersion within equities may be expanding the opportunity to clear both, and for active strategies delivered in a pooled vehicle, the wrapper may matter as much as the strategy.

Key Takeaways

• Market cap-weighted indexes have been a difficult hurdle for active managers, particularly when market leadership has been concentrated in the largest stocks.
• For taxable investors, the index hurdle is higher still, as capital gains distributions may reduce after-tax returns.
• Wider stock-level dispersion can create a richer opportunity set for active security selection and may also offer tax-loss harvesting opportunities.
• Structure matters: over the past five years, active ETFs have generally been more tax efficient than their mutual fund counterparts.¹
• Active ETFs like DYNF and THRO show what's possible. Both ETFs have outperformed more than 90% of large blend funds over the past three years on an after-tax basis.
• The after-tax toolkit can extend beyond active ETFs, with ETFs like TOPT and QTOP helping investors broaden concentrated mega-cap exposure while SMAs can offer more customized, year-round tax management.

The uncomfortable truth for active: indexing is a high hurdle

Indexing has earned its place in portfolios. In a market where performance has been heavily influenced by a small group of mega-cap leaders, broad market-cap-weighted exposure has been difficult to beat. Through August 2026, the iShares Core S&P 500 ETF, IVV, outperformed 81% of large blend funds over the past five years, ranked against 1127 funds.² This is the first hurdle actively managed strategies come up against - before considering taxes, indexes themselves have been unusually strong competitors.

Taxes can reduce already hard-to-find alpha

Even when active managers outperform cap weighted indices, taxable investors may not receive the full benefit. Capital gains distributions can erode returns, stacking a second hurdle on top of the first. Over the past year, the tax drag for large blend funds has been nearly 2%.³

Dispersion has created an opportunity

Headline numbers for index performance can look strong even when the experience beneath the surface is far more uneven. Despite the S&P 500 returning 13% YTD through August, 38% of stocks within the index are in the red, with 115 stocks down more than 10%.

This type of dispersion can make the opportunity set more dynamic and create more room for active managers to add value through security selection.

ETFs may reduce potential tax drag

Two managers running similar strategies may deliver meaningfully different after-tax outcomes depending on the wrapper utilized. Over the past five years, active ETFs have generally exhibited more tax efficiency when compared to their mutual fund counterparts.

Put simply, the wrapper doesn't generate alpha — but it can influence how much of it is kept by an investor.

All regulated investment companies, including ETFs, are obliged to distribute portfolio gains to shareholders by year-end. Trading shares of ETFs may also generate tax consequences and transaction expenses. Certain traditional mutual funds can also be tax efficient.

Active ETFs that have cleared the index hurdle

Investors may have defaulted to S&P 500 ETFs like IVV for large blend exposure precisely because the index has been so hard to beat when combined with the potential for greater tax efficiency of the ETF wrapper as compared to a traditional mutual fund. But if the bar has been set there, there are some active ETFs that still stand out.

Over the past three years, IVV outperformed 78% of large blend funds on an after-tax basis.⁴ Over that same period, the iShares U.S. Equity Factor Rotation Active ETF (DYNF) and the iShares U.S. Thematic Rotation Active ETF (THRO) each outperformed more than 90% of large blend funds on an after-tax basis. While THRO's track record does not yet span five years, DYNF's does — and on an after-tax basis, it has outperformed 97% of the category over that period.

Percentile rankings tell part of the story. On an after-tax return basis, both funds also outpaced IVV over the trailing three-year period.

Extending the after-tax toolkit beyond active ETFs

The same stock-level volatility that can create opportunities for active security selection may also create tax-loss harvesting opportunities for investors. This is particularly relevant today, as many portfolios have become increasingly concentrated in a handful of mega-cap stocks and several of those stocks are down more than 15% YTD.^⁵ For investors who own those stocks directly, the recent pullback may create opportunities to harvest losses while remaining aligned with their broader investment objectives.

That’s where TOPT and QTOP can fit. TOPT owns the top 20 stocks in the S&P 500, while QTOP owns the top 30 stocks in the Nasdaq-100. Rather than transitioning from a single stock into a broad market-cap-weighted allocation, investors can use these ETFs to broaden single-stock concentration into a basket of mega-cap leaders.

Importantly, TOPT and QTOP are not active ETFs — they are index ETFs. The point here isn't about alpha; it's that the ETF structure itself can help investors make more intentional transitions in taxable portfolios, moving from concentrated single-stock risk to more precise exposures while staying aligned with the portfolio view.

For clients who need more customization, SMA solutions can extend the tax-aware lens further. Direct indexing through tax-managed SMAs gives investors ownership of individual securities, providing greater flexibility to personalize exposures, tailor portfolios to individual preferences and manage portfolio transitions in a tax-aware manner. This more customized approach can complement the benefits offered by the ETF wrapper.

In today’s environment, it’s important to focus not just on finding alpha, but also on understanding how taxes may affect investment outcomes. Investors should consider the tax implications of their investment decisions in consultation with their tax advisors when constructing and managing portfolios. Explore the full suite of after-tax solutions offered by BlackRock here.