When direct indexing offers big tax advantages, and when it doesn't

Wealthy clients and their financial advisors are flocking to direct indexing investments, with the potential for unlimited capital-gains offsets a major reason for their appeal.

Interest in investing directly in the underlying stocks of an index rather than say, an S&P 500-linked product itself, led industry giants like Pershing, Morgan Stanley, Vanguard and BlackRock to acquire firms that are skilled in the technique that research firm Cerulli Associates projects will attract $825 billion by 2026. Other companies have built direct indexing capabilities in-house. LPL Financial became the latest to roll out a new solution earlier this month.

While lower payments to the IRS depend on a wide range of factors — especially a client's wealth — the tax-loss harvesting benefits have acted as "the No. 1 reason investors turn to direct indexing," Morningstar found in a March report. For clients to tap into the opportunity, though, the number of advisors aware of direct indexing and recommending the method to clients will have to grow beyond the mere 14% who told Cerulli they were doing so last year.

Direct indexing "gives advisors a way to create a unique client experience and to help them stand out from their peers," said Natalie Miller, the director of investment strategy at Parametric Portfolio Associates, a direct indexing asset manager owned by Eaton Vance and the firms' parent since 2021, Morgan Stanley. "Education is key for advisors, one to understand what direct indexing is and how to talk about that with clients."

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In an interview, Miller acknowledged that the need to invest in individual securities within a separately managed account "introduces some complexity" into the process for advisors and clients. In the case of LPL, the firm's research division used indices from MSCI for companies with large capitalizations, those at small- and mid-cap levels and others tracking international equities to create the firm's direct indexing products. Those SMAs are now available to the nearly 22,000 advisors with LPL through the firm's Model Wealth Portfolios platform.

"Financial advisors are always looking to help improve client outcomes and deliver personalized investment solutions," Rob Pettman, LPL's executive vice president of wealth management solutions, said in a statement. "Investors want the ability to customize their investment strategy in order to achieve a range of goals, including reducing overall tax burden and/or avoiding a particular sector or security."  

Direct indexing, also sometimes called "personalized investing," can generate extra tax-loss harvesting gains ranging from 20 to more than 100 basis points "for capital gains-rich" clients, according to a Vanguard study last year. A portfolio of individual stock holdings could rack up three times the tax-loss harvesting yield of one composed of ETFs over 20 years, a study published last month in the Journal of Beta Investment Strategies concluded.

"Investors can use realized losses to offset an unlimited amount of capital gains and can carry those losses forward indefinitely — it's not a use-it-or-lose-it situation," the Morningstar report said. "For example, if an investor realized $1 million of capital gains in a year and had $1.5 million in realized losses, they can offset the full $1 million of gains and still have $500,000 of losses as a tax 'asset' to reduce future capital gains at any future time. Investors can use up to $3,000 of realized losses to reduce their taxable income each year. For high net worth investors in the top tax bracket, it is probably better to save the losses for offsetting gains though." 

Clients must wait at least 30 days under IRS wash-sale rules to buy back the same underlying security, so the SMAs typically invest in similar stocks. The savings flow most plentifully to "those who hold significant amounts of tax-inefficient investments in taxable accounts," according to a March analysis by Morningstar Research Services Director of Research John Rekenthaler. He listed eight different factors affecting the possible tax benefits.

"Direct indexing creates a separate account that is used to generate capital losses," Rekenthaler wrote. "With frequencies that range from monthly to as often as daily, the computer programs that oversee direct-investing portfolios 'harvest' those stocks that sell below their cost bases while keeping the winners. The program reinvests the sales proceeds into the stocks of companies resembling the ones that were dropped. Rinse and repeat."

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The prospective benefits come with caveats. The direct indexing solutions analyzed by Morningstar carry starting fees of 0.20% to 0.40%, which are multiples above the expense ratios of the cheapest index funds and ETFs. Since the strategy often requires frequent turnover in a portfolio, Parametric uses tax-loss harvesting "only if the tax benefit offsets the transaction costs and if tracking error can be kept within a predetermined margin," according to the firm's website. "Tracking error" refers to the difference between a portfolio's performance and that of a benchmark.

Within that criteria, Parametric views direct indexing as a component of a "core-satellite approach" with passive products at the center and actively managed funds complementing them. By replacing the passive products with direct indexing, the losses can offset the capital gains of the actively managed funds, Miller said.

"What's important is to look at the after-tax return of those portfolios," she said. "Because of that specific focus on tax management and loss harvesting, the end result for the client is a better after tax-return."