Taxes can have a major impact on the long-term growth of a portfolio. Find out how continuous, thoughtful tax management can help investors maximize their wealth.
How did your portfolio do after taxes? I bet most investors have absolutely no idea. Everywhere you look, taxable investors are focused on pretax returns. But really, it’s after-tax returns that matter. Tax management is a way to make sure you don’t give up more in after-tax returns than you have to. But not all tax management is the same. Let’s look at how this works in direct indexing portfolios.
What should investors know about taxes?
First, let’s review some of the key features of the US tax code that influence good tax-management practices.
- Taxable event. Investors get a tax bill only if they sell a security for more than they paid for it. The tax is applied to the difference and owed in the tax year of the sale. Unrealized gains aren’t subject to tax.
- Tax-rate differential. Securities sold less than a year after purchase are taxed at a higher rate than those held for longer than a year.
- Treatment of losses. If investors sell a security at a loss, they don’t get a check from the IRS, but they can use the loss to offset capital gains elsewhere in their holdings. Any excess losses can be carried over to future years.
Although these rules are subject to change, they’ve endured over time and act in concert. That is, even if one of them were to evolve, there’s usually still plenty of value to tax management given the others.
What does tax management involve?
Tax management means being careful about realizing gains and strategic about realizing losses. There are four primary techniques:
Holding securities long enough to qualify for a lower tax rate
Selecting loss-maximizing or gain-minimizing tax lots for trades
Moving securities in or out of a portfolio in kind instead of liquidating
Avoiding purchases that would disallow losses according to IRS wash-sale rules
None of this is quite as exciting as trying to predict where the price of oil is going or which tech stock will be the next big thing. But being savvy about the tax consequences of trading can help preserve wealth in a portfolio. This gives investors more dollars to put to work in the market and can really add up over the long run. Third-party research has shown that tax management can add 1%–2% in after-tax excess returns.*
These techniques are available to any investor, but for many they’re an afterthought, addressed maybe once a year, if at all. Additionally, tax management might be at odds with the alpha-seeking goals of the manager the investor has selected. And although passive, index-based mutual funds or ETFs are relatively tax efficient, they can’t produce any additional tax benefits for the investor. The solution to all this is a tax-managed direct indexing portfolio.
How does tax management work?
In a direct indexing portfolio, investors get a core market exposure with an express focus on taxes. This portfolio isn’t just inherently tax efficient; it can produce excess losses that can then be used to offset gains elsewhere in the investor’s overall holdings.
The reason for this lies in the key difference between direct indexing and an index-based ETF or mutual fund. In an ETF or mutual fund, the investor holds a single security whose returns are based on a basket of underlying securities. But in a direct indexing portfolio, they own the individual underlying securities directly—typically hundreds of them. Hence the term direct indexing. The selection of these securities is based on a benchmark of the investor’s choosing. It can even be a custom benchmark or a blend of two or more popular benchmarks.
Owning the securities directly, and in great number, gives the investor the utmost potential to execute the tax-management techniques outlined above and helps make direct indexing a compelling choice for the taxable investor. The reason for this is the tension between the dual goals of being the market and beating the market after taxes.
To be the market, the investor needs to invest in securities that are in the aggregate similar to the benchmark. But to beat the market, the investor needs to be able to deviate from the benchmark. With hundreds or even thousands of securities to invest in, and even more tax lots than that, the investor has more flexibility to do things like defer gains or harvest losses while still getting market-like returns.
Furthermore, direct indexing portfolios can accept securities in kind and transfer them out without liquidating them. And most important, the tax characteristics of and trading patterns for each security are unique to the investor. They’re not bearing the tax consequences of some other investor’s trading and investment needs.
How tax management works in direct indexing portfolios
When does tax management work best?
As stated above, tax management really boils down to maintaining an awareness about the tax consequences of each trading decision and using a disciplined process to balance the trade-offs. Here are some things each investor should know about what can influence its success:
- Market conditions. Just like any investor process, market conditions can be more or less conducive to the tax-management goal. Tax-management benefits tend to be greater in more volatile markets and more muted in steady up markets.
- Tax conditions. Higher tax rates make the value of deferral and the offsetting of losses against gains more valuable. This is particularly so when losses are offset against short-term gains. Investors in higher-tax jurisdictions may find tax management even more compelling.
- Investor needs. Each investor is unique. Those facing a significant taxable event, those with investments that produce a lot of short-term gains, those with significantly appreciated securities, or those with charitable gifting plans may find tax management more valuable than those not in any of these situations.
The bottom line
Direct indexing is uniquely positioned to serve the needs of taxable investors. In the right hands, it can be used to form a core market exposure within the larger portfolio that’s not only tax efficient in itself but can also be used to enhance the tax efficiency of the investor’s overall holdings. This can be a boon for investor wealth over the long run.
* Shomesh E. Chaudhuri, Terence C. Burnham, and Andrew W. Lo. 2020. “An Empirical Evaluation of Tax-Loss-Harvesting Alpha.” Financial Analysts Journal 76:3, 99–108. This study did not involve Parametric or its clients. There is no guarantee that a tax-management strategy will result in increased after-tax returns. Results will differ based on an individual investor’s circumstances.