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Three Advantages of a Custom Direct Indexing for the Taxable Investor

Rey Santodomingo photo

Rey Santodomingo, CFA

Managing Director, Investment Strategy (emeritus)

An ETF may be a tax-efficient option for the taxable investor—but a custom direct indexing portfolio can be even better. Learn what else this choice can provide. 

Continuing a trend of the past five years, exchange-traded funds (ETFs) grew in assets under management (AUM) in 2020. More investors are using ETFs as they shift from active to passive investing. One favored advantage of ETFs is tax efficiency due to the low turnover associated with index-based investments, in addition to many ETF providers’ use of the creation and redemption process to reduce capital gains distributions. 

However, the fact remains that the ETF continues to be a one-size-fits-all solution that isn’t optimal for everyone. The flexibility of a custom direct indexing portfolio can beat an ETF in terms of tax efficiency in many cases. Let’s look at a few examples.

Advantage #1: Tax-loss harvesting
A custom direct indexing portfolio is a superior vehicle for delivering the value of tax-loss harvesting. This value comes through realizing tax losses that can be used to offset capital gains. In a custom direct indexing portfolio holding many securities, loss-harvesting opportunities are more plentiful because each security is a potential loss-harvesting trade. Even when the market is up, investors can still find losses in a tax-managed portfolio. With ETFs, investors need to wait for the entire market to go down before they can harvest any losses.

Advantage #2: Transition of appreciated securities or concentrated positions
A custom direct indexing portfolio allows investors with existing stock portfolios to more effectively transition to an index-based exposure over time. A custom direct indexing portfolio manager can analyze an investor’s existing securities, decide which ones to keep, and carefully sell out of non-index names, using the proceeds to invest in securities that help reduce tracking error to the index. It’s important in transitions like this to take gains and losses into account, since the sale of each appreciated security can result in capital gains taxes. A custom direct indexing portfolio manager can use the losses embedded in the portfolio to offset any gains realized.  

On the other hand, an ETF investor has a much harder time making a careful transition, because they don’t have the ability to work with the granularity of the individual stocks. Often they’re stuck with liquidating the portfolio and buying the ETF, which can trigger a large tax bill.

The benefits of systematic tax-loss harvesting

Advantage #3: Double benefit of charitable gifting
A custom direct indexing portfolio provides a superior tax-advantaged way to give to charity. This type of portfolio enables clients to gift highly appreciated securities, which provides the benefit of the charitable gift deduction and also helps investors avoid the capital gains tax associated with the position. While an ETF portfolio can also become appreciated, a custom direct indexing portfolio will contain highly appreciated securities that have outpaced the market and cap-weighted index-based ETFs in recent years—making them a much more tax-advantageous security to gift. For example, three major tech stocks went up 64% on average in 2020, compared with 18.4% for the S&P 500®.

The bottom line
To solve for optimal after-tax results, investors need to take into account key inputs that are unique to their situations. These inputs can include their portfolio’s level of appreciation; tolerance for tracking error or speed of transition; and federal, state, and local tax rates. When these variables are taken into account, the benefit of a custom direct indexing portfolio and tax-efficient management is that the investor can get a more optimal after-tax return than they can from an ETF.

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