It’s easy to think that pre-tax returns are the be-all and end-all when asking if a direct indexing account has achieved its goal. But other metrics can make or break a direct indexing experience. Explore the ways diversification, tax management and long-term plans can also help evaluate its success.
Our research has found many people asking if direct indexing is right for them. It’s a great question, and one that we’ve explored at length. But we’d like to continue that conversation in a new light. How do we know when direct indexing has been successful?
When you’ve decided direct indexing is right for your clients, you’ll find numerous ways to measure when the strategy has fulfilled its potential. Many investors think pre-tax returns are the only metric that matters, but this isn’t true in direct indexing. Let’s talk about some of the other ways we can evaluate the success of this approach.
How closely does the direct indexing portfolio match its benchmark?
Tracking error is a commonly used measure of risk in investments. It measures how consistently a portfolio deviates from its benchmark’s performance. The lower the tracking error, the less a portfolio typically deviates from the benchmark. Investors who want the advantages of a direct indexing account need to realize there will be some tracking error, which can be scary for many. Understanding the sources of tracking error and how it’s managed can go a long way in easing the fright.
In direct indexing, tracking error is carefully managed, balancing the tracking error with tax management and customization. Over half of our clients fund their direct indexing portfolios in-kind, typically with a basket of securities that have a level of concentration and appreciation, which means the account starts at an elevated tracking error to avoid a large tax bill at inception. For these clients, the goal is tax efficient diversification over time. This means trimming concentrated positions tax efficiently to reduce the risk or tracking error over time. For cash funded portfolios, a level of tracking error is used to allow for active tax management, carefully managing under-weight and over-weight securities to the benchmark to harvest losses and defer gains.
For fixed income, another strategy that can aid clients if they’re willing to experience some tracking error is a laddered portfolio. This structure effectively functions as direct indexing for bonds. Fixed income indexes can hold thousands of bonds, which makes them much harder to replicate than equity indexes.
Advisors can help investors overcome this challenge with equal-weighted laddered portfolios customized for credit quality, duration, maturity range and other characteristics. Bond benchmarks are generally only based on one or two of these characteristics. While this method also results in some tracking error, a dynamic ladder structure can act as a hedge against interest rate and tax risks—ones investors would likely face if they couldn’t tactically adjust between bond types.
Values-based investing can also introduce tracking error for the sake of customization. Direct indexing is one strategy that makes it possible to align portfolios with personal values. It’s not just environmental, social and governance concerns either, but it can also help build portfolios that reflect an investor’s faith. This will stray investors away from a benchmark, but it will keep them moving toward more personal goals.
After you’ve explained all this, your clients may still have some tracking error anxiety. That might be beyond your control, but careful management can limit tracking error. How tracking error and tax-management opportunities are balanced is one way to measure a direct indexing portfolio’s effectiveness.
Personalize tax-managed portfolios around client needs
How much return has the direct indexing investor made and kept after taxes?
Tax management opportunities in direct indexing portfolios can have a major impact on the amount your clients keep. Passive index-based mutual funds or ETFs are tax efficient and provide diversified exposure, but they can’t pass on losses to investors. In a direct indexing portfolio, an investor gets broad market exposure with an explicit focus on taxes. Owning the securities directly gives the investor more potential to execute tax-management techniques.
This is where we get into the real bread and butter of direct indexing: tax-loss harvesting. We believe direct indexing is one of the best ways to serve the needs of taxable investors. Investors get a tax bill if they sell a security for more than they paid for it, but unrealized gains aren’t subject to tax. Success is obviously measured in returns, but we also measure it in losses, which aren’t always a bad thing. If an investor sells a security at a loss, they can use the loss to offset capital gains elsewhere in their holdings. Then investors can carry over any excess losses to future years.
Investors in mutual funds and ETFs are also limited in their investment options to exposures available in the funds. With direct indexing, exposures can be customized to meet investor’s unique goals. To invest in mutual funds and ETFs investors must liquidate existing investments, which will likely have tax consequences. Direct indexing portfolios can accept securities in kind, making investment more tax efficient. All these techniques used together correctly may aid investors in keeping more after taxes.
Is the direct indexing portfolio helping the investor’s long-term plan?
Now that the advisor has used all the tools at their disposal to make a direct indexing account work for the investor, only one more thing really matters. At the root of it, is the investor on track to meet the goals they set for their household when they began investing? If the answer is yes, we’d consider that a definite success.
This means understanding the investor’s previous experience and perspective on investing to build the right portfolio for them. While we believe it’s better not to get hung up on short-term figures with direct indexing, some investors might not want to fully diversify and realize the gains needed to do so. Direct indexing could still be for them with the right solution. Everything from adjusting allocations to overweight or underweight certain market sectors, combining multiple benchmarks to achieve an investor’s desired exposure, and screening out certain industries or companies that don’t align with their values is possible with direct indexing. Managers can match the investor’s pace and goals and recommend other techniques when the investor is reassured by direct indexing’s power.
The bottom line
Whether the client has long- or short-term goals, the success of direct indexing depends on the investor and advisor fully understanding its benefits and limitations. Investors should carefully consider if the benefits of diversifying and making the most of after-tax returns is worth some tracking error for their long-term goals. We think using the measures we’ve laid out will show managers and investors alike if their direct indexing portfolios are meeting the mark.
Investment strategies that seek to enhance after-tax performance may be unable to fully realize strategic gains or harvest losses due to various factors. Market conditions may limit the ability to generate tax losses. Tax-loss harvesting involves the risks that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. Also, a tax-managed strategy may cause a client portfolio to hold a security in order to achieve more favorable tax treatment or to sell a security in order to create tax losses. Prospective investors should consult with a tax or legal advisor before making any investment decision.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
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