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Direct Indexing, Tax Loss Harvesting, and Customization

·3 min read

This article was originally published on ETFTrends.com.

Direct indexing is a $350 billion market and is thought of as the next wave in investor solutions. In the panel The New Kids on the Block… Or Are They? A Direct Indexing Conversation Ritholtz Wealth Management Investor advisor Blair duQuesnay, Vanguard’s Jonathan Hudacko, and AllianceBernstein’s Gavin Romm explored why this segment of the market is growing, where the risks lie, and how to best deploy solutions.

“It's almost like the SMA reimagined,” duQuesnay said of direct indexing.

Romm thinks that the U.S. tax code supports direct indexing and that it can be “a super utilities play.”

Hudacko concurred, noting that plenty of advisors have sold stocks or bonds at a loss to create a tax return for their clients. “You need a manager, a process, or some sort of way to capture that for your clients.”

The panel noted that there is a focus on raw performance, and not many investors give enough weight to taxes. “People see munis as a tax efficient investment,” Romm said, “but above and beyond that the way you run the strategy can create greater tax efficiency.” With high transaction costs in fixed income, the tax benefits of selling can be obscured on paper. “It takes work, but you do need to think about how you can actively manage those taxes.”

ESG customization is a huge part of direct indexing. ESG means something different to every client, noted duQuesnay.

Hudacko says direct indexing can help clients meet their specific needs. Hudacko used an example of a vegan investor who might want a “vegan portfolio.” The ability to tailor a portfolio to a client’s needs and values can create a powerful appeal.

The Challenges of Direct Indexing

Hudacko notes that it is a product ideally started in cash. “That’s optimal for this type of strategy, but not essential.”

The panel discussed the utility of completion portfolios for working toward transitioning to or from products like ETFs or mutual funds. “I think we’re exposing some of the hidden costs of investing that have traditionally transpired,” Romm said.

“Most of us don’t have the skill to pick winners on a consistent basis,” Hudacko said, making the case for technology and process-enabled investment strategies like direct indexing over traditional stock picking.

Customization Nation

Direct indexing can be a very easy way to execute factor or sector exposures and customize exposure to a client’s needs. “Everything is more personalized and customized now,” Romm said. “I think the world is changing.”

Romm sees the technology and infrastructure as critical to not overwhelming an advisor with a million different choices and levers, noting mutual funds and ETFs don’t need a UI.

Tax Alpha

“You are typically looking, if you do nothing and let a direct index provider loss harvest, you typically have five to seven years,” said Hudacko. Eventually, securities tend to increase in value, so prolonged loss harvesting can’t last forever and tends to be strongest in the opening salvo before degrading over time. Hudacko believes there are ways to extend the life of these accounts.

duQuesnay asked how we can report the benefits of tax loss harvesting to clients. Hudacko says shadow benchmarks are a typical tactic employed here, urging people to google “tax harvest alpha” to find white papers on this.

Romm said after tax return report cards are useful to give clients a report on what happened and how effective their tax harvesting was.

Is This a High Net Worth Product?

Hudacko believes these strategies can benefit even smaller retail investors, though he doesn't deny high net worth individuals benefit a lot. Hudacko said, "once fractional shares become standard issue, then you start to think about the size of the account so it's optimally about harvesting the loss that's best for that client."

Romm says fractional bonds are "possible" in the future, but sees such things as years out.

For more news, information, and strategy, visit VettaFi.

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