It’s not for everyone—some clients can have portfolios that realize little or no recurring capital gains on their taxable accounts, and some of the downsides of direct indexing (ossification, concentration and higher costs) may make mutual funds and ETFs better investment vehicles.
“DTHL is very beneficial with people who have material recurring capital gains. They’re holding something tax-inefficient through, say equity investments. If they have $10,000 gains and you can offset that with losses, you go from taxes to no taxes,” Jaconetti said. “Who else might have recurring gains, other than tax inefficient in taxable accounts? People with highly concentrated positions. They might think over time they’d like to diversify but they don’t want to pay the tax bill. As you’re selling out you can use it to offset gains.”
In general, she said, retirees should sell their tax-advantaged accounts first, but if they have a very large taxable portfolio, they might want to consider pairing it with direct indexing to make the most of distributions from the taxable side of their investments.
Direct indexing also benefits clients who will have a future capital gain event, such as selling a business. “You can carry forward any losses, and each year you can offset $3,000 in ordinary income,” she said.
In addition, advisory practices that work to generate higher returns through actively managed equity mutual funds and ETFs, private equity, hedge funds and other alternative investments can benefit from direct indexing on behalf of their clients. Pairing these lucrative but tax-inefficient investments in taxable accounts with direct ownership of securities and access to daily tax-loss harvesting is likely to result in higher after-tax outcomes than if none of the strategies were employed, the paper said.
Advisors who should consider direct investing for their practice including those dedicated to access management and those who use private equity and hedge-funds.
Evaluating Cost
According to Vanguard, the average cost of direct indexing is now roughly 25 basis points, while the cost of investing in a mutual fund or ETF is more like 5 basis points. But deciding how much to invest in direct indexing is not an all-or-nothing strategy, as for many portfolios an advisor could invest only as much as is needed to off-set gains and investing the rest in cheaper options.
When analyzing the trade-offs of using direct indexing over a mutual fund or ETF, in general, the larger the expected alpha and the amount of gains to be offset, the greater the portion of an equity portfolio that could benefit from direct indexing.
For example, in a Vanguard-provided, hypothetical scenario where a client has a $1 million portfolio, a capital gains rate of 20%, a 20 basis point difference between direct indexing and lower cost mutual funds/ETFs, zero expected alpha and $5,000 of capital gains to be offset, the expected benefit from implementing direct indexing would be $1,000 (expected alpha plus tax savings).
That means that with a $1,000 benefit, an advisor could allocate up to 50% of the equity portfolio to a direct investing program, as the expected alpha plus tax savings is equal to the estimated cost at 50% of the portfolio. Allocating more than that would exceed the expected alpha plus tax savings, and therefore a mutual fund or ETF would be superior for that part of the portfolio. Allocating less than that would be wasted opportunity.
“It’s a great new development, but not for everyone,” Jaconetti surmised. “It really depends on if portfolios are set up efficiently. If people have gains, or want to hold actively managed funds, that’s when they might want to look at it.”