​DIRECT INDEXING: Is direct indexing right for me?

Key Takeaways:

• Direct indexing adds value when working with a taxable client/portfolio
• If you need to transition a portfolio of legacy/inherited securities, direct indexing can help
• A single-stock concentrated position can be addressed in a direct index solution
• When a client has customization needs, direct indexing can be a great solution

One of the most frequent questions we hear is “how do I know if direct indexing makes sense for my clients?”  This is a great question and should be one of the first steps in looking into separately managed accounts (SMA), direct indexing, and many of the components of direct indexing.  Below are some of the most common scenarios that we run into when working with clients:
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• Taxable Client / Portfolio - If you have a taxable client, chances are there are advantages of using a direct index solution.  Tax benefits can come in many different forms.  Just look at the utilization of mutual funds and then ETFs over the last 50 years.  It was identified that by changing the investment vehicle and structure, a taxable investor could benefit.  Mutual funds provided lower cost access to diversification and capital markets.  Moving from Mutual Funds to ETFs allowed an investor to benefit from the creation/redemption process allowing in-kind payment so investors do not incur most capital gains in the investment vehicle.  Direct indexing is the next step in this progression.  Owning the underlying securities in an SMA vehicle (which does not happen in ETF and Mutual Fund vehicles) allows the investor to benefit from the gains and losses of the individual securities themselves.  The result is a term called “tax alpha.”  In simple terms, tax alpha measures how much better off your portfolio is on an after-tax basis.  Direct indexing can either defer the realization of gains or realize losses to offset gains elsewhere in the portfolio.  Both of which can be very beneficial to a taxable investor.

• Legacy / Inherited Securities – Even if an advisor does not typically manage their client assets in SMA vehicles, chances are their clients either have or will have individual securities at some point.  Alternatively, every advisor has worked with a prospective client that is coming over from a firm/advisor that managed individual securities.  One of the biggest advantages of a direct index portfolio is that it can accommodate legacy individual stocks.  Most of these stocks have some form of embedded gains.  Consequently, as an advisor you can either sell the positions and incur a large tax bill for the client or you can retain the stocks.  Direct indexing allows you to retain the positions, defer incurring he gains, but still construct a portfolio that is transparent, tracks an index, and meets your client’s overall portfolio allocation goals.

• Concentrated Positions – Have you ever worked with a client that has one or a handful of large, concentrated positions?  Inevitably, we all run into this scenario and it is a difficult one to overcome.  The concentrated position creates several issues including reduced diversification, over-concentration in sectors/industries, and a general deviation from your desired portfolio allocation.  Stock specific risk is real, and it can impact your client’s long-term investment objectives.  Direct indexing can help in a couple of ways.  First off, direct index vehicles help an advisor construct a portfolio around the concentrated position to attempt to reduce the concentration and impacts on portfolio allocation, thus reducing idiosyncratic risk caused by the concentrated position.  Secondly, direct indexing can generate losses which can then be used to offset gains incurred when you sell out of the concentrated position.  SmartHarvest can take this concept a step further by implementing other concentrated position solutions like single stock call writing and synthetic exchange fund creation.  These are more advanced solutions that we can implement with third-party partners in the option/derivative space.

• General Customization – This category includes many different client needs.  Technically speaking, taxes, concentrated positions, and legacy securities are all client-specific issues that require a truly customized solution.  But we can take customization further in many different directions.  If a client has particular Socially Responsible (SRI/ESG) views that they would like reflected in their portfolio, direct indexing allows for a very customized solution that can address all of their needs.  We can customize stock or industry specific views or a general theme like human trafficking, animal cruelty, and much more.  Maybe your firm has a very specific view on markets that requires a particular asset allocation.  This can include a particular exposure to asset classes, factors, securities, sector/industry, etc.  All of these can be customized to meet the needs of your firm allocation or client need. 

 
Direct index investing may not be necessary in all scenarios, but it can make a lot of sense for many clients and portfolios.  The complexity of these scenarios can range from simple, a taxable client that would benefit from tax loss harvesting and superior after-tax returns, to a more complex scenario in which a client has legacy stock holdings, embedded gains, a concentrated position, a very nuanced tax situation, charitable gifting needs, and SRI/ESG views.  Most clients only have one or two of these needs, but direct indexing can resolve one or all of these scenarios for you and your clients.  Have a particular client situation?  Just let us know, we are happy to talk through it with you.

​TAX LOSS HARVESTING: ​What is tax loss harvesting and why is it important in my portfolio?

Key Takeaways:

• The primary goal of a tax managed direct index strategy is to achieve index returns pre-tax, and outperform index returns on an after-tax basis.
• Investors can generate superior after tax returns (“Tax Alpha”) by harvesting losses in their portfolios to offset gains and income taxes.
• Harvesting losses does not mean investors have to sacrifice achieving index/benchmark returns.
• A significant number of strategies, including active SMA, mutual fund, and ETF vehicles, underperform their benchmarks by a significant margin when looked at on an after-tax basis.

 
There are few things in investing that are both important and controllable.  Opinions vary on what these things are, but most of the investment community agrees that costs and taxes are two of the most important factors to consider when managing a portfolio of investments.  In this article, we’ll highlight the importance of taxes, specifically tax loss harvesting.

The concept of Tax Loss Harvesting is understandably difficult to comprehend as we are ingrained to view gains as good and losses as bad.  Consequently, most investors stop here and ask themselves, “why would I want losses in my portfolio and how can that be a good thing?”  The answer is two part; (1) pre-tax returns should always be a primary objective of the taxable investor, but an equally important objective is (2) what steps should I be considering when looking at after-tax returns?  David Swensen, head of the Yale Endowment and creator of The Yale Model, infamously stated in 2007 that, “A minuscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent (annual) margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.”  Or in other words, it’s incredibly difficult to beat index/benchmark returns on a pre-tax basis, and even more difficult on an after-tax basis.  The primary tool used to combat the deterioration of returns on an after-tax basis is tax loss harvesting.

Below are some important topics to understand when discussing tax managed portfolios and tax loss harvesting:

1. Tax loss harvesting is a tool that is best utilized in a separately managed account.  The taxable investor needs to own each individual security to claim the losses, which cannot be done in commingled portfolios like ETFs and mutual funds.
2. A well-executed tax managed solution should seek to target index/benchmark returns on a pre-tax basis while harvesting losses throughout the year to provide superior after-tax results.
3. Losses are used to offset gain obligations elsewhere in your portfolio.  Additionally, the short-term and long-term status of the gains/losses are important.
4. A tax managed account that utilizes tax loss harvesting does not completely eliminate an investor’s tax obligation.  It simply defers the obligation while capitalizing on the compounding effect of not paying taxes immediately.

So how does tax loss harvesting work?  Primarily, there are three ways a tax loss harvesting strategy can improve tax efficiency and generate superior after-tax returns.  (1) Investment losses help to reduce taxes paid by offsetting a taxable investor’s gains and income, (2) losses can be carried forward and deferred indefinitely to other periods if you do not immediately have gains to offset, and (3) a taxable investor can use up to $3000 of losses to offset ordinary income on federal income taxes as well.  Another concept to consider when harvesting losses is the type of gain/loss.  Securities held for under a year are subject to a short-term loss/gain and those held longer than a year are considered a long-term loss/gain.  Short term gains are subject to the much higher ordinary income tax rate, which can be upwards of 37% or even higher if subject to the NIIT.  Long term gains however are subject to a much lower capital gains tax rate.

How does harvesting losses effect pre-tax returns?  An investor does not have to settle for inferior pre-tax returns to successfully implement a tax loss harvesting strategy.  A tax managed direct index portfolio buys a basket of securities with the goal of tracking the investor’s desired benchmark/index.  The portfolio is then managed on an on-going basis using an optimization process that analyzes dozens of underlying risk factors (sector, market cap, value, growth, etc) to build a portfolio that walks and talks like the underlying index.  When a security is at a loss, the security is flagged in the system for tax loss harvesting, the security is sold, the loss is harvested, and the optimizer selects another security, or basket of securities, to replace the security that was sold at a loss.  After this process, the portfolio behaves the same as it did before; continuing to capture the index return while also harvesting losses.
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In summary, a tax managed direct index account can help you achieve index returns on a pre-tax basis and outperform on an after-tax basis.  The goal of this article is simply a high-level overview of tax loss harvesting to help explain its importance in achieving superior after-tax performance.  Please keep an eye out for additional articles that discuss this concept more in-depth.  Additional topics include Tax Alpha, Tracking Error, Wash Sale Rule Violation, and Customization including SRI/ESG and factors.