The two most predictable sources of alpha in this world are fees and taxes; unfortunately, they are both negative and reduce investor returns. That is why we believe investment results should be evaluated on a risk-adjusted basis, after the deduction of fees and taxes. Although this is not an original thought; sound investment advisors are always looking for ways to mitigate the impact of fees and taxes for clients.
Over the past decade or so, a popular strategy to potentially reduce the impact of fees on a portfolio has been to invest in low-cost mutual funds and/or exchange-traded funds (ETFs) that mirror a benchmark index. As an example, a S&P 500 Index mutual fund or ETF essentially owns, in exact proportion, all the stocks that comprise the S&P 500 Index. Often these passive index strategies have outperformed more costly active managers. While relatively tax efficient, these vehicles are unable to fully take advantage of short-term market volatility. In recent years, lower trading costs coupled with enhanced technology has made direct indexing an attractive alternative to a portfolio of low-cost mutual funds and ETFs.
With direct indexing, an investor directly owns a basket of individual stocks that closely track a designated benchmark index. Using optimization software, the manager can identify and purchase a subset of the index constituents while still closely tracking the benchmark’s performance. Owning a basket of individual stocks affords the manager greater flexibility during periods of volatility to selectively harvest losses while still maintaining a low tracking error to the benchmark. The idea here is that individual stocks tend to experience much higher volatility (compared to a diversified mutual fund or ETF), which increases the opportunity for tax loss harvesting. Realizing losses in a portfolio can be used to offset capital gains, thus saving taxes. Failing to harvest losses during periods of short-term volatility (regardless of when it occurs) may lead to sub-optimal results, essentially leaving money on the table through lost opportunity costs.
As a thought experiment, consider a market where the index return is in an upward trend. Even though the index is in an upward trend, some of the underlying stocks that comprise the index are likely not following the trend. Owning an index mutual fund or ETF would benefit the investor by participating in the positive market exposure, yet with very little opportunity to harvest losses. That is because the index fund’s performance is the net return of a collection of individual stocks. Conversely, a direct indexing strategy presents the opportunity to selectively sell individual stocks at a loss and establish new positions to maintain exposure to the index.
The benefit of direct indexing is the potential creation of “tax alpha” in two primary forms. First, in practice, these strategies tend to predominately harvest short-term losses and take, or realize, long-term gains. For an investor that has other investments that are less tax efficient and routinely generate short-term gains, the short-term losses generated by this strategy can offset those short-term gains and as a result 1) gains are deferred and 2) when gains are eventually taken, they are more likely to be long-term. This creates a form of tax arbitrage as long as long-term tax rates are lower than short-term tax rates. Second, even in the case where outside gains are long-term in nature, this programmatic loss harvesting essentially creates a shift in basis allowing for extended deferral of gains as long as the beta exposure is desired.
Fact patterns are important, but if the goal of the investor is to mitigate taxes while maintaining diversified exposure to the market, direct indexing for a portion of an investor’s equity exposure may be a good option to consider.
Neale Ellis, CFA, CPWA is a founding partner and Co-CIO at Fidelis Capital. Matthew Michaels, CFA, CFP, is a founding partner and Co-CIO at Fidelis Capital.