January 30, 2023 | Vanguard Perspective
Capitalize on market volatility with direct indexing
Bear markets and a looming recession can stress out your clients, especially when they see the unrealized value of their portfolios drop. Fortunately, you can take advantage of market volatility by tax-loss harvesting to potentially improve your clients' after-tax returns. By far the most efficient and scalable way to do that is by leveraging direct indexing technology like Vanguard Personalized Indexing.
As a reminder, a direct indexing portfolio is a separately managed account where the investor owns individual stocks that represent a chosen benchmark index. Because investors directly own each stock in their portfolios, they gain extra opportunities for tax efficiency that may not be possible with ETFs and mutual funds.
Find a silver lining in market swings
With bundled products like mutual funds and ETFs, you're not able to isolate losing stocks for tax-loss harvesting. With direct indexing, you're able to sell individual stocks at a loss in a client's portfolio to offset capital gains, even when the benchmark index is up.
Recent software innovations in direct indexing technology have automated processes such as scanning for tax-loss harvesting and rebalancing opportunities, allowing you to scale up what used to be a time-consuming process—and preventing your clients from missing out on opportunities you might not have time to implement on your own.
Volatile markets provide an abundance of opportunities for tax-loss harvesting, since periods of loss in the stock market are often quickly followed by periods of rebounds. In addition, when markets are in high volatility mode, volatility is likely to persist in the near term, with the best and worst days tending to cluster around each other. This can be seen in the chart below. During such periods of market volatility, the automatic tax-loss harvesting feature of direct indexing technology really shines.
For instance, Vanguard Personalized Indexing uses sophisticated tax-lot and wash-sale management to scan daily for tax-loss harvesting opportunities. As a result, we can help you harvest losses more aggressively during a volatile period, helping generate additional after-tax alpha for your clients without expending extra effort.
The best and worst trading days often happen together
S&P 500 Index daily price returns January 1, 2020, through December 31, 2022
Work around the wash-sale rule
Here's how Vanguard Personalized Indexing helps you capitalize on volatile markets without violating the wash-sale rule.1 During an initial market downturn, our daily tax-loss harvesting scan flags an account for tax-loss harvesting opportunities. Our expert team of portfolio managers reviews each opportunity the system identifies to ensure it will drive positive outcomes for your clients. If approved, the account is traded to realize losses, and those trades are added to a restriction file.
A few days later, if the market continues dropping, our system flags the account again for significant tax alpha opportunities. When losses are harvested this time, our software avoids the securities in the restriction file. This prevents investors from being locked out of the market for 30 days due to the wash-sale rule, and missing tax-loss harvesting opportunities that occur close together.
You can use harvested losses to offset a client’s capital gains on stocks, the sale of a home or business, and up to $3,000 of ordinary income each year (as of the 2022 tax year). Plus, losses can be carried forward to future years indefinitely.
Of course, not every client is positioned to benefit from the tax-loss harvesting feature of Vanguard Personalized Indexing. Some may not have enough recurring capital gains to offset realized losses. However, for your high-net-worth clients with realized capital gains on the order of at least 3% to 4% of taxable equity holdings per year, daily tax-loss harvesting with Vanguard Personalized Indexing can make a meaningful difference—roughly doubling the amount of harvested losses they generate.2
In a volatile year like 2022, tax-loss harvesting can provide a welcome opportunity to make use of capital losses and potentially help your clients keep more of what their portfolio makes.
Offer tax efficiency and customization
In addition to the potential for improved after-tax alpha for your clients, Vanguard Personalized Indexing also gives you the ability to customize their portfolios to align with their unique preferences and values; apply factor tilts; and diversify around concentrated positions. Consider how personalized indexing technology might help you differentiate your practice while giving appropriate clients the tax-efficient, customized investing experience they expect.
1 The IRS doesn't allow an investor to sell an investment at a loss and then immediately repurchase it (known as a "wash sale") and still claim the loss. If the investor buys the same investment or any investment the IRS considers "substantially identical" within 30 days before or after the investor sells it at a loss, the loss will be disallowed. If you need guidance on whether an investment would be considered substantially identical, consult a tax advisor.
2 Kevin Khang, Alan Cummings, Thomas Paradise, and Brennan O'Connor, 2022. Personalized indexing: A portfolio construction plan. Valley Forge, Pa.: The Vanguard Group. Simulation as of September 2021.
- Vanguard Personalized Indexing Management, LLC ("Vanguard Personalized Indexing Management"), formerly Just Invest, LLC, an SEC-registered investment advisor, is an independently operated wholly-owned subsidiary of The Vanguard Group, Inc. ("Vanguard"). Vanguard Personalized Indexing is an asset management technology that has been developed and is offered solely by Vanguard Personalized Indexing Management.
- For more information on Vanguard Personalized Indexing Management and Vanguard Personalized Indexing, and to access Vanguard Personalized Indexing Management's Form CRS and Form ADV Part 2A disclosure brochure, please visit the Vanguard Personalized Indexing topic page.
- All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
- Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. Prospective investors should consult with their tax or legal advisor prior to engaging in any tax-loss harvesting strategy. Neither Vanguard Personalized Indexing Management nor Vanguard provide tax or legal advice.
- The material contained in this document is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The information contained herein may be opinions, which are subject to change, at any time, and should not be construed as financial or investment advice on any subject matter.
- The information contained herein does not constitute tax advice and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code. Each person should consult an independent tax advisor about their individual situation before investing in any security.
- Factor investing is subject to investment style risk, which is the chance that returns from the types of stocks selected will trail returns from U.S. stock markets. Factor investing is subject to the risk that poor security selection will cause underperformance relative to benchmarks or funds with a similar investment objective.
- ESG portfolios are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the data provider for ESG criteria generally will underperform the market as a whole or, in the aggregate, will trail returns of other portfolios screened for ESG criteria. The data provider's assessment of a company, based on the company’s level of involvement in a particular industry or the data provider's own ESG criteria, may differ from that of other portfolios or of the advisor's or an investor's assessment of such company. As a result, the companies deemed eligible by the data provider may not reflect the beliefs and values of any particular investor and certain screens may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the customized investment strategy will depend on the data provider's proper identification and analysis of ESG data.
- All performance results have been compiled by VPIM and have not been independently verified.
- Index performance does not reflect the deduction of expenses but does reflect reinvestment of dividends, capital gains, or interest.
- Indexes are unmanaged, therefore direct investment is not possible.