As direct indexing offerings have matured, advertised promises of great economic benefit have proliferated. To distinguish hype from opportunity, advisors and their clients considering this approach over traditional equity indexing strategies should review the four key drivers that make direct indexing worthwhile for tax purposes, including the availability of outside capital gains to be offset by losses—which IRS data show applies to only 8% of taxpayers.

Introduction

Over the past couple of years, the investment industry has experienced a surge in interest and enthusiasm for direct indexing, also known as custom indexing or personal indexing. Such strategies frequently emphasize automated tax-loss harvesting, though that’s only one feature of direct indexing. The goal of this approach is often to replicate fairly closely an equity benchmark while generating capital losses and offering other customization features such as values alignment, factor tilts, or exclusion of specific stocks. For nearly 25 years, Aperio has emphasized the tax benefits of indexed equity separately managed accounts, always acknowledging that direct indexing isn’t right for all situations. We urge all investors and advisors to “do the math” as we have and discern when direct indexing might offer great benefits for certain types of investors, usually those in higher tax brackets who also have outside capital gains.¹

Though such strategies can suit investors whose concerns extend beyond tax efficiency, here we’ll focus on just the economics of the potential tax benefit, relying on an analogy from the analysis of municipal bonds (munis). For taxable bond investors seeking superior after-tax yields, it’s widely understood that munis can best benefit those in higher tax brackets, whereas such investors in lower brackets may be better off in taxable fixed-income securities. Arriving at the best decision requires doing a little math.² On the equities side, increasing numbers of tax-aware investors who want broad market exposure can now choose between directly owning the shares of a selected benchmark or buying traditional indexing pooled vehicles such as exchange-traded funds (ETFs). To analyze the tax benefits and drawbacks of these approaches, an investor’s marginal tax rate matters enormously, as it does with munis, but investors should consider three additional variables in considering direct indexing, as we discuss in detail below.

Drivers of tax benefits from direct indexing

Focusing on just the potential tax impact, direct indexing can add value by generating capital losses that can be used to offset certain types of capital gains. For investors choosing between direct indexing and ETFs, the four key factors to consider are: (1) the amount and nature of outside gains; (2) the investor’s marginal tax bracket, as with munis; (3) the account’s eventual disposition; and (4) the time horizon.

1. Amount and type of outside capital gains

The benefits of losses materialize only when coupled with gains, so a first measure of whether direct indexing might be the appropriate choice is the availability of capital gains outside the portfolio, especially short-term gains. For example, taxable investors who hold only mutual funds of any type will typically see less benefit from loss harvesting since short-term gain distributions from mutual funds do not flow through to Schedule D on a tax return, instead getting taxed as ordinary income like bond coupon payments. Taxpayers with net capital losses are allowed to apply up to $3,000 against ordinary income, but if an investor is paying more in fees for these strategies than for straight indexing, that limited benefit in many cases can’t provide enough value to justify choosing direct indexing over an indexed ETF in the absence of gains.

2. Tax bracket

The benefits of loss harvesting are limited for taxpayers in the lowest brackets, especially those who pay a 0% tax rate on long-term capital gains. For very high-income taxpayers, especially those in states with high income tax rates, the tax benefits can be substantial.

How many taxpayers across income levels might benefit from direct indexing? This table shows a summary of recent Internal Revenue Service data on the amount of capital gains by income. Note that on an aggregate basis for all income levels shown, about 92% of taxpayers had no capital gains at all.* Thus, even a high tax bracket by itself usually isn’t enough to justify choosing a direct-indexing approach over traditional equity indexing without gains to offset.

Amount of gains by bracket

* Presumes all taxpayers with short gains also have long gains.

Source: “Internal Revenue Service Data Book, 2019,” October 1, 2018, to September 30, 2019, www.irs.gov/pub/irs-prior/p55b--2020.pdf.

3. Disposition of assets

The investor’s preferred account disposition scenario—liquidating a portfolio at the end of the holding period or passing the assets through an estate or to charity—also impacts the potential tax efficiency of a direct-indexing strategy. The tax benefits can be much higher for the estate/charity situations.

4. Time horizon

Significantly, the length of time an investor holds a direct-indexing account also affects the potential tax benefit. For liquidation situations in particular, the advantage derives from the time value of money, so holding such an account for only a year or two won’t add much value because that’s not much time for the benefit of deferral.

Conclusions

Direct indexing has evolved from a strategy available only to the very wealthy to one now accessible to retail investors. Frequently, the democratization of certain types of investment strategies can level the playing field more, allowing retail investors to access what had previously been unavailable. However, as with municipal bonds, tax brackets make a huge difference to the tax benefit of direct indexing, as do outside gains, an account’s disposition, and the time horizon over which a portfolio is held. As direct indexing matures as an offering, advisors and investors will increasingly need to do the math to determine in advance when these strategies appear worthwhile and when they do not. Consumers should make sure they understand the nuances of any investment strategy and not be seduced by attractive-looking numbers that may or may not apply to their specific situations. Financial advisors seeking more information, including detailed numbers by bracket and gain amount, can contact aperio.clientservice@blackrock.com to receive comprehensive research, available only to financial professionals, that shows the math for a wide range of client situations.

Send questions or comments to aperio.blog@blackrock.com.

¹ Internal Revenue Service (IRS), “Internal Revenue Service Data Book, 2019,” Publication No. 55-B, June 2020, www.irs.gov/pub/irs-prior/p55b--2020.pdf. Our review of IRS data shows that for the roughly 8% of taxpayers who do have capital gains, those losses can prove quite valuable, but for the 92% who have no gains, the tax benefits of direct indexing may be limited.

² For example, if in a taxable account investors facing a 40% marginal tax rate were to buy a taxable bond paying a 5.0% coupon, they would earn an after-tax return of only 3.0% [5.0% x (1 – 40%)]. If they could buy a municipal bond paying a tax-exempt 3.5%, they’d earn 50 basis points more on an after-tax basis. However, if investors with a 20% marginal tax rate were to buy the same taxable bond, their after-tax return would be 4.0%, higher than the after-tax return on the muni.

Important notes

Aperio Group, LLC, provides this material for informational purposes only. The information contained herein is provided with the understanding that we are not engaged in rendering legal, accounting, or tax services. We recommend that all investors seek out the services of competent professionals in these areas. The strategies and/or investments referenced may not be suitable for all investors, because the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. None of the examples should be considered advice tailored to the needs of any specific investor or a recommendation to buy or sell any securities. The fees and expenses Aperio charges may be higher than the fees and expenses of other investment advisors and may offset profits. Additional information about the firm, and our fees and expenses, is included in our Form ADV.

Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal, or volatility of returns. There is no guarantee that any investment strategy discussed herein will work under all market conditions. Many factors affect performance, including changes in market conditions and interest rates, as well as other economic, political, or financial developments.

You should not assume that investment decisions we make in the future will be profitable or will equal the investment performance of the past. With respect to the description of any investment strategies, simulations, or investment recommendations, we cannot provide any assurances that they will perform as expected and as described in our materials. Past performance is not indicative of future results.

Any tax information provided herein is for illustrative purposes only and does not constitute the provision of tax advice by Aperio. Due to the complexity of tax law, not every single taxpayer will face the situations described herein exactly as calculated or stated, i.e., the examples and calculations are intended to be representative of some, but not all, taxpayers. Since each investor’s situation may be different in terms of income tax, estate tax, and asset allocation, there may be situations in which the calculations would not apply. Please discuss any individual situation with tax and investment advisors first before proceeding. For those clients using tax advantaged indexing, taxpayers paying lower tax rates than those assumed, or without taxable income, would earn smaller tax benefits from tax-advantaged indexing (or even none at all) compared to those described.

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