Is Direct Indexing Right for Me?

Introduction

You might benefit from “direct indexing” if:

• You have a large (>$1million) taxable securities portfolio.
• You are in a high tax bracket.
• You expect to be in a lower tax bracket in retirement.
• Your taxable investments generate a lot of capital gains, particularly short-term gains, such as is often the case with actively managed funds and hedge funds.
• You are making substantial annual deposits into your taxable account, perhaps because you are retired and not spending your IRA required minimum distributions.
• You are making substantial annual charitable contributions and like the idea of contributing highly appreciated stock rather than cash.

Direct indexing is an alternative to investing in an index fund. Rather than own shares in, say, an S&P 500 index fund, in a direct index portfolio the investor owns most or all of the 500 individual stocks in the index. This is not something investors do for themselves—it is a specialized form of portfolio management, offered mostly by larger investment advisors. The primary rationale for direct indexing is tax savings, mostly through “tax-loss harvesting.”

What is Tax-Loss Harvesting 

Tax-loss harvesting (TLH) involves intentionally selling securities at a loss in order to reduce taxes. The amount of the loss equals the selling price minus the original cost (“tax basis”). If the selling price is above the tax basis, there is a gain and tax will be owed. Losses can be used to offset gains.

TLH only applies to taxable accounts. Selling securities in an IRA account is not a “taxable event.” It has no tax consequences.

Most brokerage and mutual fund statements list “realized” and “unrealized” gains and losses on a year-to-date basis for each security. Gains and losses are “realized” when a position is sold.

When you sell a security for more than what you paid for it (its “tax basis”), you will owe tax on that gain. Gains on securities held for one year or less are considered “short-term” and are taxed at ordinary income tax rates of up to 37%, the same as earned income. However, gains on securities held longer than a year are taxed at preferential “long-term” capital gains rates. For most people, the rate will be 15%, although for very high earners it can be 20%. (There is also a 3.8% Obamacare surtax on net investment income for married couples who have an adjusted gross income of more than $250,000—or $200,000 for single filers.)

When you file your taxes, you must “net” your gains and losses against each other. First, short-term gains and losses are netted against each other. Then long-term gains and losses are netted. Finally, the results of those two calculations are netted.   If the net is a loss, you will be able to reduce your ordinary income by up to $3000 (applying net short-term losses first). Any unused net loss, short- or long-term, can be carried over into future years. A capital loss that is carried over to a later tax year retains its long-term or short-term character.

Because short-term gains are taxed at higher, ordinary income tax rates, the realization of short-term losses is particularly attractive because they can offset short-term gains that would otherwise be taxed at high rates. (The realization of long-term losses will reduce your long-term gains first, but those rates are lower, so offsetting them is not as valuable.) Consequently, if you have investments at a loss that are about to become long-term losses, it may be worthwhile to harvest the losses while they are still short-term losses.      

Here is an example of the yearly netting of capital gains and losses:

• Short-term gains: $6,000
• Long-term gains: $4,000
• Short-term losses: $2,000
• Long-term losses: $15,000
• Net short-term gain/loss: $4,000 ST gain ($6,000 ST gain - $2,000 ST loss)
• Net long-term gain/loss: $11,000 LT loss ($4,000 LT gain - $15,000 LT loss)
• Final net gain/loss: $7,000 long-term loss ($4,000 ST gain - $11,000 LT loss)

Only $3,000 can be deducted  against other types of income for that year. The remaining $4,000 net long-term loss must be carried forward into the next year. It will first be used to offset any capital gains in that year, and if any net loss remaining can be used to offset up to $3,000 of income in that year, and so forth.

Sometimes, only part of a position is sold. In such cases, the “tax lot allocation method” becomes important. Most brokers and mutual funds use the FIFO (“first in, first out”) method by default. In most cases, this turns out to be exactly what you do NOT want to do, since over time markets tend to rise, so the oldest shares (the “first in”) are likely to have the lowest tax basis and therefore generate the most in capital gains. I have found that the “Highest Cost” or “HIFO” (highest in, first out) method results in the lowest capital gain in nearly all cases, so I have set that as the default method for my clients’ taxable accounts.

One more thing. The IRS will disallow the loss for a “wash sale,” defined as the sale in which the taxpayer sold and repurchased the same (or a “substantially identical”) security within 30 days. However, it is entirely allowable to purchase another highly similar security. For example, in 2022 I sold Vanguard Growth ETF (VUG) and switched into Schwab U.S. Large-Cap Growth ETF (SCHG) in many taxable client accounts. Then a little more than 31 days later I switched back from SCHG to VUG, and realized another set of short-term losses. Switching to an ETF that uses a different index (even if it is highly similar) is not considered a wash sale.  

What is Direct Indexing?

When you buy an S&P 500 index fund, you own a single security. If the index price falls below your original cost, you can harvest the loss by selling the index fund. But since markets tend to rise over time, the chances for tax-loss harvesting a broad index fund are limited.

However, if you invest in a direct index of the S&P 500, you may own all 500 securities individually. Because of the dispersion of individual stock returns, even if the overall index is up relative your cost, it is likely that some of the individual securities will have declined in price, giving you an opportunity for tax-loss harvesting.

For example, let’s assume that the index has only two securities, stock A and stock B. Each stock is purchased for $100. Over the next year, the price of stock A increases to $120. The price of stock B falls to $90. The overall index is now worth $210 ($120 + $90), for an overall capital gain of $10. If you owned an index ETF, there would be no opportunity to harvest any loss. However, a direct index that includes both A and B will facilitate the harvesting of the $10 loss in stock B.

TLH with ETFs vs Direct Indexing

ETFs are very tax-efficient securities, which is explained in “Why Invest Using ETFs?” Investing in style, size, and factor indexes breaks a portfolio into securities that may behave differently than the overall asset class. For example (as mentioned above), in 2022, growth stocks vastly underperformed value stocks in the U.S., which provided a good opportunity for harvesting the losses in growth stocks. In many cases, using these targeted ETFs can be an “80% solution” that provides some of the same benefits as direct indexation without the attendant costs and complexities. In the previous example, “A” and “B” could have been labeled “value” and “growth,” or “large-cap” and “small-cap,” or “U.S.” and “international,” or “short-term bonds” and “long-term bonds.”

However, under certain circumstances, the higher trading and management costs associated with direct indexation are justified because the higher level of granularity that owning individual securities provides more abundant opportunities for tax management as measured by “tax alpha.”

What is Tax Alpha?

The benefit of direct indexation is measured by its “tax alpha” (or “tax benefit”). Tax alpha is the after-tax portfolio return minus the after-tax benchmark index return. If the risks of the portfolio are very close to the risks of the index (the portfolio “tracking error” is low), the excess return is assumed to be “alpha,” or risk-adjusted excess return.

Tax benefits arise from two distinct sources:  1) “character” benefits and 2) “deferral” benefits.  Character benefits involve tilting the balance of net realized gains away from short-term and toward long-term and away from ordinary income and toward qualified dividends and tax-exempt income. Deferral benefits involve the deferral of realizing capital gains. Character benefits are permanent, resulting in a lower tax rate. Deferral benefits are temporal—the gain and its attendant taxes are delayed into the future. The economic benefit of deferring gains comes from the time value of money and the investment return on the money that would otherwise go to pay taxes. However, the IRS will eventually get its pound of flesh. Unless appreciated securities are given to charity or there is a step-up in basis at death, the deferred capital gains tax will ultimately have to be paid.

To illustrate character benefits, suppose that a security has been sold for a $1000 short-term capital gain. Barring any further action, that short-term will be taxed at the taxpayer’s ordinary income tax rate, which may be as high as 37%. However, if the taxpayer’s portfolio also contains another position with a $1000 loss (whether short-term or long-term), harvesting the loss will completely offset the gain. Losses are normally transitory. Over time, markets rise, and so do most securities. Offsetting short-term gains is particularly valuable because of their high tax rate. By harvesting a $1000 capital loss, the short-term capital gains tax on the $1000 gain has been avoided.  

Who Should Consider Direct Indexing?

The higher the expected tax alpha, the more likely that a direct index strategy will be worth the costs. There are many variables that affect tax alpha. One study found that about 40% of the expected tax alpha is related to market dynamics which cannot be known in advance:

• Market return – lower is better. A lower market return means that securities will be priced below their cost more often, presenting more opportunities for tax-loss harvesting.
• Cross-section stock return dispersion—higher is better. A higher level of cross-sectional dispersion means that, at any given level of return for the overall market, a greater number of individual securities will trade below their cost.

However, about 60% of the expected tax alpha is explained by variables that can be estimated to some extent ahead of time:

• Marginal tax rates—higher is better. Higher tax rates on ordinary income, short-term capital gains, and long-term capital gains increase the value of avoiding or delaying those taxes.
• Spread between current tax rates and “liquidating” tax rates (say, in retirement)—higher is better. If liquidating taxes are lower, the value of deferring gains is higher because high current tax rates are avoided and low future tax rates are substituted.
• Percentage of the portfolio that will ultimately be liquidated—lower is better. Liquidation can be avoided with charitable contributions or step-up in basis at death. This is an extreme example of the previous point, since securities contributed to charity are never taxed and accumulated capital gains are also avoided with the step-up in basis at death.
• Amount of “external” annual capital gains—higher is better. Direct indexing is particularly valuable to taxpayers whose investments outside of the direct index portfolio generate capital gains. Active mutual funds, for example, often distribute capital gains annually.
• Percentage of “external” capital gains that are short-term—higher is better. Direct indexing is even more valuable to taxpayers whose investments outside of the direct index portfolio generate short-term capital gains. Many hedge funds and commodity pools have this characteristic.
• Amount of annual cash contributions to direct index portfolio—higher is better. Cash contributions will “refresh” the direct index portfolio with new, higher cost basis positions, providing renewed opportunities for tax-loss harvesting.
• Amount of annual charitable giving from direct index portfolio—higher is better. Regularly “harvesting” the securities with the highest gains and donating them to charity can eliminate the “lock-up” problem that applies to highly-appreciated positions. Realizing the capital gains in these securities would be enormously expensive. Sometimes these positions get so large that they are contributing a large amount of stock-specific risk to the portfolio.

There are also interaction effects. The value of most of the above variables is affected by the marginal tax rate. The higher the tax rate, the more important it is to avoid paying ordinary income tax rates (for example, due to realizing short-term capital gains) and to delaying paying any taxes (by harvesting losses) or by avoiding them altogether (through charitable contributions or step-up in basis at death).  

Suffice it to say that estimating the expected tax alpha for a given taxpayer is extremely complex and highly uncertain. However, some very meticulous studies have been done to try to measure the marginal impact of the above-listed variables.

Quantifying Tax Alpha

Goldberg, Hand, and Cai (2019) found that the ultimate disposition of the direct index portfolio was a particularly large influence on its average tax alpha since inception. They found that direct index portfolios that were ultimately either inherited by beneficiaries (with a step-up in basis) or donated to charity achieved a median tax alpha of .98% per year. Those that were liquidated had a median tax alpha of .63%. The highest federal marginal tax rates were assumed in their study of 20-year holding periods.

Note in the graph below how much lower the tax alphas are for liquidated portfolios relative to inherited or donated portfolios. Also note how the median tax alpha drifts downward over time. Often the best tax alpha for a direct index portfolio occurs in the first or second year, when the losses for securities that start out below cost can be harvested. Over time, prices tend to rise, limiting the opportunity for tax-loss harvesting.

Source: “Rewards and Risks of Loss Harvesting Strategies", Goldberg, et. al. (2019)

A study with more explanatory variables over 15-year time periods was performed by several researchers from Vanguard and published in the Financial Analysts Journal in 2021. Their study took its data from the Federal Reserve “Survey of Consumer Finances” from 1982 to 2019 (inclusive) and focused on four archetypal investor “types” segregated by income. “Type 1” investors had an income of $130,000, only 2% of the value of their total assets in “loss-offsetting income” (capital gains against which losses could be used to lower taxes), and only 5% of their taxable equity assets in annual cash flow contributions. 75% of the taxable portfolio was assumed to be ultimately liquidated. The initial ordinary income rate was 22%. The characteristics of “Type 2” investors were somewhat similar, with higher income, cash flow, and tax rates. Both groups could be described as “mass affluent” investors.

At the other end of the spectrum are “Type 4” investors, with extremely high levels of income, cash flow, and taxation. These are the “ultra-high net worth” investors most likely to have very large taxable portfolios that include hedge funds and commodity pools that generate a lot of capital gain income. They are able to add 50% per year to their taxable portfolios on average (from executive stock awards, real estate investments, and inheritance). Careful and complete estate planning ensures that none of their assets will be exposed to ultimate liquidation. These are the historic investors in direct index portfolios. They and the Type 3 “high net worth” investors are mostly likely to benefit enough in terms of tax alpha to make the incremental costs worthwhile.

The Vanguard study found that about 40% of the variability in tax alpha could be explained by time-series sequence of returns and return volatility, but the remaining 60% resulted from investor characteristics. Foremost among these was tax rate. The authors concluded that “direct indexing may not result in a meaningful tax-loss harvesting alpha for a broad swath of investors.” For investor Types 1 and 2, “TLH alphas are not meaningfully greater than zero after accounting for reasonable management fees for direct indexing.” They considered a tax alpha above 100 basis points “meaningful” enough to warrant direct indexing.

Source: “Tax-Loss Harvesting: An Individual Investor’s Perspective,” Financial Analysts Journal (Vol 77, 2021)

The table above simplifies the detailed sensitivity analysis of the Vanguard study by presenting only averages. The detailed study used regression analysis to separately measure the marginal impact of each variable on tax alpha. The most powerful investor variables were found to be the two tax rates (initial and liquidating) and the amount of annual loss-offsetting income. Annual cash contributions and the ultimate percentage of the portfolio that was liquidated were significant but not as important.

In 2022, three researchers from AQR published a paper entitled “The Tax Benefits of Direct Indexing: Not a One-Size-Fits-All Formula” in the Journal of Beta Investment Strategies. Their detailed study also used regression analysis to isolate the marginal impact of a number of variables. Like other studies, they found that the tax benefits decay quickly with time. In the graph below, the tax alpha for the first five years (blue bars) is much higher than for the later years (orange bars). Also, in keeping with other researchers, they found that tax alpha is much higher in the presence of unlimited short-term capital gains to take full advantage of tax-loss harvesting opportunities. Note that the tax alpha is much higher with STCG (short-term capital gains). The alternative assumes no short-term capital gains—only long-term capital gains. Tax alpha is greatly increased in the presence of 1%/month cash contributions. It is further enhanced by 1%/month charitable contributions of the most highly appreciated securities.

The most conservative “base case” for most investors is to assume that the only way to utilize net losses is to offset $3,000 of ordinary income. Most investors do not have consistent short-term capital gains to be offset, nor do they have monthly cash contributions available to contribute to a taxable account, nor do they harvest highly appreciated positions for charitable contributions. The resulting “base case” tax alpha of about .50% is not generally considered high enough to justify the expense and complication of direct indexing. (As mentioned above, the critical threshold is often considered to be about 1%.)

However, the situation for affluent investors may shift once they are taking required minimum distributions from their IRAs. Many affluent retirees find that they do not really spend all of the RMDs, and that they end up adding to their taxable accounts with the leftover amounts. And even if they are not inclined to give 1% of their taxable account balance to charity every month, that outcome may be reasonably approximated with the assumption that capital gains in their taxable accounts will be delayed as long as practicable with the intention of allowing the next generation to inherit with a stepped-up basis.

Source: “The Tax Benefits of Direct Indexing: Not a One-Size-Fits-All Formula,” Sosner, et. al., (2022)

Summary and Conclusions

• Direct indexing involves owning most or all of the securities in an index individually in order to maximize tax-loss harvesting (TLH) prospects.
• TLH is most constrained by owning very broadly diversified funds. In such cases, TLH is entirely based on the sequence of market returns.
• Owning more narrowly defined individual ETFs with a low correlation to each other provides more flexibility for TLH, but is still heavily path-dependent. (Higher time-series volatility and lower cross-sectional correlation among the individual ETFs will enhance TLH opportunities.)
• Direct indexing maximizes TLH flexibility, but is still highly influenced by the sequence of market returns, market volatility, and cross-sectional dispersion of individual securities.
• The marginal benefit of direct indexing is measured by “tax alpha,” or the incremental after-tax return of a direct index portfolio over an equivalent ETF or index fund.
• Direct indexing is generally considered attractive only if expected tax alpha exceeds about 1%.
• Only investors in the highest tax brackets are likely to achieve a tax alpha above 1%.
• However, affluent retirees who do not spend all of the required minimum distributions from their IRAs may also be candidates for direct indexation because they can add significant cash to the portfolio over time, “refreshing” it for TLH purposes, and because they may be able to avoid capital gains altogether by using stepped-up basis at death.