While direct indexing, also called personalized indexing (PI), sounds new and exciting, it really is just the next step in a long history of customization for clients, said Colleen Jaconetti, a certified financial planner and accountant who is a senior manager in Vanguard’s Investment Advisory Research Center.
“We had separately managed accounts for a very long time, and people have done personalized indexing since the ‘90s,” she said. “What’s different now is the commissions are low to zero, you have the ability to own fractional shares, and advancements in technology have provided scale. Advisors maybe did this for 12 clients in the past. Now they can do this for hundreds of clients. It’s much more manageable.”
Jaconetti was the author of a recent whitepaper, “Benefits of Personalized Indexing: Improve after-tax investment outcomes for your clients,” that delved into the tax-loss harvesting (TLH) benefit specifically.
“Most high-net-worth investors, and the advisors who manage their portfolios, are extremely tax-averse; therefore, getting to zero realized capital gains is a critical investment objective to maximize after-tax returns,” she wrote, adding that advisors will use both investment products and financial planning techniques (like evaluating all investments held in taxable accounts on an after-tax basis, sticking to tax-efficient investments, using tax-efficient rebalancing and tax-efficient drawdown, and avoiding expensive tactical asset allocation) to get to zero realized capital gains.
However, those highly tax-efficient portfolios also may end up being portfolios that are less than optimal compared with portfolios that could be constructed if tax-efficiency weren’t the main criteria for investment selection.
For example, many wealthy clients have most of their assets in taxable accounts in light of the IRS limits on contributions to tax-advantaged accounts, like 401(k)s, so advisors tasked with maximizing after-tax returns often end up using the limited space in those tax-advantaged accounts for actively managed equities and other tax-inefficient investments like taxable bonds, which might have higher returns than the tax-efficient investments that make up the majority of the client’s portfolio.
For some of these high-net-worth investors, where the higher cost of direct indexing can be justified by the bottom-line benefit, using direct indexing within taxable accounts can result in higher after-tax returns.
Who Benefits
The clients who benefit most from direct indexing are those in higher tax brackets and who currently have significant and recurring capital gains that are expected to continue, estate plans with charitable intent or an expected step-up in basis, a portfolio holding highly appreciated and concentrated sector or style exposure, and new contributions that will be added to the direct indexing account throughout the investment period.
“One problem that can arise with systematically harvesting tax losses is that eventually the magnitude of stocks at a loss in the portfolio will diminish with time,” Jaconetti wrote. “Because of the potential capital gains that would result from selling those low-cost-basis stocks, switching to another investing strategy could be costly. For this reason, PI with TLH is more effective when there are meaningful new contributions to the investment portfolio throughout the investment period.”
Without those new cash infusions, the investment account will suffer from cost-basis “ossification,” which occurs when the daily tax loss harvesting (DTLH) reduces the number of securities with losses over time, making it harder to use this benefit, she said. Similarly, portfolio concentration might increase, as those insufficient tax-loss harvesting opportunities reduce the ability to diversify. And finally, portfolio staleness might occur, which is what happens when a portfolio resembles the winning stocks at the time the portfolio became active, not the stocks of the present.