Direct indexing versus ETFs and mutual funds
October 25, 2022
October 25, 2022
Your clients, like most people, don’t like paying taxes. Period. And paying more taxes than necessary is even worse. That’s why maximizing their after-tax returns is one of your critical objectives. Direct indexing (also known as personalized indexing) is one effective way to potentially lighten the tax drag on your high-net-worth clients. But how can you decide whether direct indexing or traditional strategies like index ETFs and mutual funds would improve your clients’ after-tax alpha more effectively? New research from Vanguard has answers.
As a reminder, a direct indexing portfolio is a separately managed account (SMA) based on a benchmark index. In contrast with a traditional SMA, it offers scalable, automatic tax-loss harvesting.
Prior research has shown that direct indexing with daily scans for tax-loss harvesting opportunities—like you get with Vanguard Personalized Indexing—can increase after-tax alpha by from 20 basis points to well over 100 basis points for a direct indexing investor with extensive recurring capital gains.¹
The tax-loss harvesting feature of direct indexing also offers you the opportunity to increase your clients’ allocations to active equity strategies, like hedge funds and private equity. It not only helps increase clients’ available “shelf space” for actively managed equity strategies, but it also lets you shelter taxable bonds in clients’ tax-advantaged accounts, maximizing clients’ after-tax returns.
Our researchers suggest that pairing active equity funds and ETFs (or other tax-inefficient investments) with direct indexing with daily tax-loss harvesting scans is likely to result in higher after-tax wealth outcomes than if neither of these strategies was used.
Which of your clients are most likely to benefit from improved after-tax alpha through direct indexing? Look for clients in higher tax brackets experiencing one or more of these four common situations:
Request a demo today to discover how Vanguard Personalized Indexing can help deliver additional value to you and your clients.
Direct indexing can help boost after-tax alpha for some, but not all, investors. Some of your clients might be better served by traditional strategies like index ETFs and mutual funds. The following factors should help you decide whether to implement a direct indexing strategy for a given client:
Our researchers created this decision tree to outline the key decision points and help you determine what percentage of a client’s portfolio to allocate to each strategy.
As you can see, there is no one-size-fits-all allocation to direct indexing. The correct allocation is highly dependent on variables like the expected magnitude and frequency of capital gains and the existing market environment. As a general rule of thumb, the larger the expected alpha and the amount of gains to be offset, the greater the portion of the equity portfolio that would potentially benefit from Vanguard Personalized Indexing.
Get detailed analysis in this Plain Talk® white paper that can help you decide whether your high-net-worth clients would benefit more from direct indexing or traditional strategies like ETFs and mutual funds.
1 Kevin Khang, Alan Cummings, Thomas Paradise, and Brennan O’Connor, 2022. Personalized indexing: A portfolio construction plan. Valley Forge, Pa.: The Vanguard Group.
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