How Direct Indexing Can Reduce Your Clients’ Taxes

There are several ways to reduce investment-related taxes, but one of the best solutions also happens to be one of the newest. This solution is Direct Indexing, and it has become much more available to investors in recent years. This article will explain what Direct Indexing is and how it can potentially reduce your clients’ taxes. Before defining Direct Indexing, it is helpful to describe the most used diversified investment vehicles: mutual funds and exchange traded funds.

Mutual funds are pooled investments, where multiple shareholders give money to a professional manager to build a portfolio according to a certain mandate. Mutual funds can hold stocks, bonds, and other types of securities. Mutual funds are great for their diversification—for example, an investor can buy a Large Cap Stock mutual fund rather than do hours of research on which Large Cap Stocks to include in their portfolio. The main drawback of mutual funds, however, is that they are required by law to distribute at least 95% of their capital gains each year to their shareholders. This is frustrating enough for long-term shareholders of a mutual fund—while they have enjoyed the investment returns that led to those capital gains, it is inconvenient to lack control over when they realize those gains. For recent buyers, though, mutual funds can be disadvantageous. An investor could buy a mutual fund a week before the fund makes a capital gain distribution, and this investor would take the same tax hit as investors who have held the fund for years. This is fine in an IRA where capital gains don’t get taxed but creates the potential for a huge tax drag in a taxable brokerage account.

Exchanges Traded Funds (ETFs) are like mutual funds in that they help an investor immediately diversify into a pool of securities according to a certain mandate. The key difference from a tax perspective, however, is that although ETFs can pay capital gain distributions, they rarely do because of the underlying mechanism of their construction. It is beyond the scope of this article to explain ETF construction, and it is also not relevant to our topic to describe other comparative advantages between mutual funds and ETFs but suffices to say that ETFs are more tax efficient than mutual funds. Are ETFs the peak of tax efficiency, though? In fact, there is an even better game in town called Direct Indexing. The reason why is best illustrated with an example.

Imagine that you buy an ETF on January 1st that tracks the S&P 500 index of stocks. Over the next six months, the index (and thus your ETF) enjoys a 10% return. Importantly, though, while the index has gained 10%, 150 of the underlying stocks are negative over that same period. If you owned those stocks directly you could realize the capital losses for offsetting gains elsewhere or reducing your ordinary income by up to $3,000 in a year. However, because you own the ETF, no such tax loss harvesting opportunity exists.

This is where Direct Indexing comes in. Rather than buy a mutual fund or ETF, an investor can hire a manager (often the same manager as their preferred mutual fund or ETF) that will manage an account in the investor’s name by directly owning the appropriate stocks. This gives the investor the best of both worlds: the immediate diversification gained from a mutual fund or ETF with all the tax efficiency of owning every stock directly. An investor can customize their Direct Indexing strategy in several different ways. Most relevant to our topic of taxes, an investor can set parameters that dictate thresholds for when losses are harvested, and to what extent a manager may deviate from its mandate to achieve those losses. In addition, the investor may be able to blend multiple indexes within an account to further diversify their portfolio; an investor can also instruct the manager to apply ESG screens, filter out certain stocks or retain certain stocks that hold sentimental value. Direct Indexing is also useful when employed

for charitable giving. If an investor determines to gift a certain dollar amount worth of appreciated stocks to charity, the manager can identify which stocks the client should give to maximize the tax efficiency and fidelity of the portfolio.

While Direct Indexing has existed in a limited capacity for decades, its availability has proliferated in recent years. This has reduced the portfolio size thresholds for implementing a direct indexing strategy, in some cases, with certain strategies applied to as little as $100,000. This proliferation has also increased competition within the Direct Indexing industry, with several service providers offering better client experiences and lower costs. The cost of Direct Indexing routinely comes in lower than that of many mutual funds and ETFs.

If you have clients who are frustrated every year when they learn how much tax liability has been generated by their investments, Direct Indexing may be appropriate for them. There are a few things to consider when assessing whether a client is a good candidate. The biggest hurdle for transitioning a client to a Direct Indexing portfolio is that they may already have large unrealized gains, meaning that some gains must be realized as part of the transition. This may rule out some clients, but Direct Indexing managers can often incorporate legacy holdings into the client’s portfolio, thus reducing or eliminating the taxes from transition. Transitions can also take place over multiple tax years to further mitigate the tax impact. Another consideration with Direct Indexing is that the client may not be used to seeing hundreds of holdings in their accounts. For those used to seeing 10-12 mutual funds in their brokerage account, this can be a minor annoyance but should be worth it for the immense tax saving opportunities. Finally, Direct Indexing’s benefits accrue the most to stock-based strategies. Many clients should diversify beyond stocks into bonds and other uncorrelated assets. As a result, it is often necessary to have two accounts—one dedicated to direct indexing and one dedicated to non-stock holdings.

Taxes will always be a necessary evil of investing. While it may not be appropriate for everyone, a solution like Direct Indexing can help your clients keep as much of their earnings as possible in their pockets rather than paid to the IRS. While the savings can be substantial in any given year, the true value of Direct Indexing manifests over time as the investor avoids the “tax drag” effect on the creation of their wealth. Please contact ACG if you would like to learn more about Direct Indexing for your clients.

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