An Ideal Tax Setup for Direct Indexing

by Gibson Capital June 18th, 2021

Former Fed Chairman Paul Volcker once remarked that the ATM was the only financial innovation he could think of that has improved society. It’s true that big, important changes in finance do not come around all that often. The advent of the Exchange-Traded Fund (ETF) was one of them. Now some suggest direct indexing will be the next big thing and will supplant both mutual funds and ETFs.


What is Direct Indexing?

Think of direct indexing as the ability to build a completely customized stock portfolio and own the individual stocks rather than via a pooled vehicle like a mutual fund or ETF. The possible parameters for customization are vast—environmental, social, and governance criteria; various financial metrics; risk parameters—you name it. Some investors also may derive a tax benefit from owning the individual stocks. We’ll get into that in a minute.

Direct indexing is not an altogether new concept. We have used custom separate accounts of individual stocks for clients for more than a decade. The new part is the availability of technology to offer these accounts to investors at lower minimums and zero commission trades at many custodians.


The Tax Benefits of Direct Indexing

The investors who will benefit from direct indexing the most are those that want to customize their stock portfolios and those who can take advantage of the possible tax benefits. The tax benefit comes from the ability to “harvest” capital losses. Imagine owning an index mutual fund that earns 10% in a given year. Now contrast that with having an account with 200 stocks that tracks that same index. In the aggregate, the stocks produce a return of approximately 10% in that same year, but the dispersion of returns for the individual stocks may be wide. Some may have returned more than 50% while others may have declined by 20% or more. Selling those that have declined and reinvesting the proceeds creates capital losses that can offset capital gains, thereby deferring taxes.  

How to Treat Unrealized Gains

Over time, however, the opportunities to harvest losses decline. After several years of recognizing available capital losses, the composition of the account will begin to skew toward stocks with unrealized gains. Investors who can solve that problem with the following strategies tend to derive the most significant benefits from a tax-managed separate account or direct index:

  1. Contribute regular cash inflows. Regular cash inflows into the account help to “reset” cost basis via new stock purchases, which creates additional future loss harvesting opportunities.
  2. Donate stocks with high unrealized gains. Donating stocks at significant gains helps to rebalance the account and removes potential future capital gains. 
  3. Intend to leave the assets to heirs who receive a “step up” in cost basis. Leaving the stocks to heirs at one’s death or donating the assets to a charity eliminates the embedded gains. 

A Real-Life Example 

We work with a client that has roughly $2 million invested in a tax-managed separate account as part of a broader portfolio. Over a three-year period, the performance of the account tracked the return of its benchmark while producing a tax benefit that a mutual fund or ETF would not have.


Three-Year Account Summary

Because the client has significant capital gains each year from other investments, the realized losses saved the client approximately $85,000 in taxes. Moreover, the client donated some of the big “winners,” those stocks with the highest percentage gains, thereby removing approximately $375,000 in embedded gain (the difference between $700,000 and $325,000 in the table above). The client occasionally adds new cash to the account to keep the process going.  

A Common Misconception

“Just think of all the losses we could generate!” isn’t exactly what the client wants to hear.

One of the biggest challenges from the practitioner viewpoint is explaining the potential benefits of this approach in a compelling way. It is easy for the client to conflate tax losses with investment losses. Careful education and collaboration with the client can mitigate this risk.


The Future of Direct Indexing

Direct indexing or custom separate accounts still cost more than index mutual funds and ETFs. The increase in cost can make sense if the benefits are more significant. However, if the cost differential converges somewhat and account minimums decline, we anticipate more situations in which a direct index is the best fit for clients. If you would like to discuss the direct indexing trend or how we incorporate direct indexing in client portfolios, please drop us a line.

As Chief Investment Officer, Chris leads our investment research agenda as well as our portfolio management philosophy and client service initiatives. He is continuing our legacy of innovations to convey complex advisory concepts to clients and professional audiences alike. Chris has professional experience ranging from high-net-worth portfolio management to comprehensive financial planning. As an investment advisor, Chris manages all aspects of client relationships.

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