Direct indexing and the benefits
Direct indexing is where an investor directly owns shares of companies in an index. Historically, the ability to directly own a broad index was limited to investors with large amounts to invest; however, technology and regulations now enable investors to own fractional shares or a portion of one share, so investors can directly own part of a company at smaller asset balances. Direct ownership conveys several benefits to investors, one of them being tax loss harvesting. First, an investor can customize the portfolio to meet specific needs or in accordance with particular philosophies or beliefs. Second, an investor can take advantage of tax rules related to directly holding a share. Third, the investor can exercise greater influence over a firm’s corporate governance via voting proxies or selling out of the position. Of these benefits, only tax management is quantifiable.
Direct indexing as a tax management tool
Unlike with a mutual fund or ETF, a direct indexing investor holds economic interest in the company, so the investor can realize a gain or loss upon selling the position. Most direct indexing tools in the market today promote tax management and efficiency features, primarily through tax loss harvesting. This is when an investor sells shares to recognize a loss to reduce taxes owed on realized capital gains and/or ordinary income. The critical question is whether tax loss harvesting adds value over the long term and if every investor benefits equally from this approach.
Several recent studies have sought to confirm earlier long-term academic and industry analysis on tax benefits derived from tax loss harvesting. Despite the optimistic marketing materials and dense mathematical analysis, conclusions about the true long-term benefits of systematic tax loss harvesting are … it depends on the investor’s facts and circumstances.
In research conducted for Vanguard in October 2020 and a later article in the Financial Analysts Journal of the CFA Institute, Kevin Khang Thomas Paradise and Joel Dickson found that the volatility environment, capital gains available to offset, and investors’ current and future tax rates are critical determinants of the benefit of tax-loss harvesting. Specifically, they highlighted the following critical features as being important to determining whether this is the right tax management approach:
- Recurring cash flows: More frequent and larger cash flows diversify cost bases and improve the ability to harvest, resulting in higher benefits.
- Market volatility: The greater and more frequent the volatile periods, especially shortly after investment, the more prevalent the opportunities to harvest losses.
- Capital gains availability: More capital gains turn more loss harvests into additional re-investment.
- Tax basis over time: The repurchase price has an impact on the longer-term tax benefits / costs associated with tax loss harvesting.
- Tax rates: The greater the present tax rate relative to the future tax rate, the greater the benefit of overall tax minimization.
Northfield, a risk management analytics provider, has been making similar arguments for many years. Even Canvas, an early direct indexing and tax loss harvesting adopter, have concluded tax loss harvesting requires sophisticated tools and analysis and may not be right in all circumstances. Other wealth managers contend that tax efficiency improvements from loss harvesting are less than buy and hold investing and that advisors and investors should “… not let the tax tail wag the dog. Selling an attractive long-term holding for short-term tax reasons generates costs and risks that tend to overwhelm the benefits.”
Conclusion
Direct indexing is probably best suited to investors motivated by particular issues, beliefs or highly specific objectives. Improved tax management and efficiency can drive significant value, but maximizing this benefit requires understanding an investor’s specific facts and circumstances in a given tax year and long-term planning. Tax loss harvesting is but one approach for better tax management and it may not be the optimal method for a given investor or time period.
