With transaction-based pricing charges lower than ever, the real challenge in direct indexing is how to get the portfolio better aligned to the investor’s chosen benchmark. Choosing the right number of securities can be the key to minimizing tracking error and maximizing loss-harvesting opportunities.
A lot has changed since Parametric started handling tax-managed separately managed accounts (SMAs) more than 30 years ago. We planned the first accounts in spreadsheets, and clients received paper confirmations for every trade placed in their accounts. Trading costs were also much higher. When I started at Parametric as a portfolio manager in 2012, it wasn’t uncommon for accounts with transaction-based pricing (TBP) to pay $8.95 per trade. TBP charges have gradually declined since then, reaching zero for many clients in 2019.
One of the important inputs when determining how many positions to hold in a direct indexing portfolio is transaction charges. Parametric has adapted to these and other changes in inputs throughout the years. With transaction charges being less of a focus for most clients, determining the right number of securities to hold is focused more on minimizing tracking error and maximizing tax-loss harvesting opportunities. Let’s walk through the decision process for how many positions to hold in a direct indexing portfolio.
What’s the value of more positions in a direct indexing account?
Investors may need time to get used to the number of positions held in a direct indexing portfolio compared with an actively managed account. An active strategy often has much more concentration than an index, holding maybe 30 to 50 positions. But a direct indexing portfolio holds closer to the number of names in the index. For example, a typical account benchmarked to the S&P 500® at Parametric may hold 300 to 400 positions. An account with a broader exposure, such as an account benchmarked to the MSCI ACWI—which contains domestic, developed international, and emerging markets exposure all in one—may hold 600 to 800 positions.
So why do we hold so many positions in a direct indexing portfolio? First, the goal of a direct indexing account is to provide similar pretax exposures and performance to the chosen benchmark, whatever that benchmark may be. As a portfolio holds more names within the benchmark close to the benchmark weight, the portfolio is better aligned to the benchmark from a risk perspective. From an after-tax perspective, since we don’t know which names within an index will present loss-harvesting opportunities over any given period, holding more names presents more potential chances for loss harvesting.
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What’s the impact of more positions on tracking error?
The goal in building a direct indexing portfolio is to construct one that will look like the investor’s chosen benchmark. Instead of trying to fully replicate the portfolio and holding every position within the benchmark at its index weight, a direct indexing portfolio is a sampled portfolio consisting of a subset of the holdings within the benchmark. Direct-indexing providers using a full-risk model, such as the type we offer at Parametric, will construct the portfolio to align to the benchmark at the security, sector, and industry level. We also help control risk factors like size, dividend yield, and momentum exposure.
The fewer the number of positions held, the larger the significance of the overweighting and underweighting of securities in the account. For example, an S&P 500® account that holds only 100 to 150 positions may take on more potential tracking error by limiting the number of positions. Parametric typically holds 300 to 400 positions in a S&P 500® account. The top 100 positions represent roughly 71% of the S&P 500®, while the top 400 represent almost 97.5% of the benchmark by market cap weight.
What’s the impact of positions on tax alpha?
The decision on the number of positions to hold can also impact the potential tax alpha of an account. In a direct indexing portfolio, most positions are held relatively close to the benchmark weight. When harvesting losses in some of the larger positions in the benchmark, investors need to decide how much of a position to sell to balance the realized losses with the potential performance deviations that arise from holding the security underweight relative to the benchmark.
Let’s assume that the maximum underweight for loss harvesting is the same, regardless of the number of positions held. When more positions are held in the portfolio, there are more potential opportunities for generating losses. Put more simply, when more names are held, there’s more potential tax alpha, since we don’t know which securities will provide loss-harvesting opportunities.
The bottom line
The number of positions to hold in a direct indexing account is one of many decisions to make when constructing tax-managed SMAs. It’s important to understand the potential benefits of holding more positions, from both a tracking error and a tax alpha perspective. A direct indexing manager should thoroughly study each setting of the optimization, including the number of positions to hold, and continue to research ways to improve their clients’ portfolios.
