Direct indexing versus ETFs and mutual funds

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.

Boosting after-tax alpha with direct indexing

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.

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.

Deciding which clients could benefit

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:

• Significant, recurring, realized capital gains. Consider clients who hold active equity, private equity, and other hedge-fund-like investments or who are retired and take distributions to meet their annual spending needs.
• Estate plans with charitable intent or an expected step-up in basis. Donating highly appreciated investments in taxable accounts to charity can help eliminate taxes since nonprofits don’t owe federal income tax on gifts.
• Portfolios with highly appreciated, concentrated sector or style exposure. Look for clients who want to reduce a highly appreciated or concentrated position, but only if they can offset taxes.
• Meaningful new contributions to the investment portfolio throughout the investment period. Clients who infuse meaningful new cash into the portfolio can help delay portfolio ossification (the point at which there are no more stocks at a loss in the portfolio).

Putting direct indexing to work for 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:

• The frequency and magnitude of recurring capital gains in the portfolio.
• The extent to which those gains can be offset by harvesting losses on assets held in taxable accounts.
• The expected alpha to be generated from holding preferred tax-inefficient investments (such as actively managed equities and private equity) in taxable accounts.
• The client’s capital gains tax rate and the relative cost difference between a direct indexing strategy and index mutual funds or ETFs.

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.

Notes:

• 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 and 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 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.