When it comes to finances, it’s not just what you earn, it’s what you keep. Earnings are subject to capital gains taxes that must be paid when an investment is sold. Many times, investors turn to passive investments such as index funds and exchange-traded funds (ETFs) to help manage taxes, but even these passive solutions can only do so much. That is why direct indexing can play a valuable role in a tax-efficient investment strategy, especially for high-net-worth investors.
How direct indexing investing works
Direct indexing is an equity investing strategy where individual stocks are purchased to create a portfolio that mirrors the performance of a preselected index, such as the S&P 500® Index. The primary objective is to replicate the performance on a pretax basis and optimize returns on an after-tax basis.
Direct indexing investment strategies can potentially enhance after-tax returns through tax loss harvesting, which involves selling a stock when its value declines and substituting it with another security. This enables investors to record the loss for tax purposes.
Direct indexing and tax-efficient returns
View video to learn how direct indexing separately managed accounts offer diversified stock exposure and the power of tax loss harvesting – plus how they compare to index mutual funds and ETFs.
Index mutual funds and ETFs are reasonably tax-efficient, but investors must still pay taxes on their dividends and periodic capital gains distributions. For tax-sensitive investors, there may be a better way to index, using direct indexing through a separately managed account, also known as an SMA.
Direct indexing using an SMA has several distinct benefits over index funds and ETFs. It can still provide diversified stock exposure, but instead of holding a single position in a mutual fund or ETF, investors own perhaps hundreds of underlying stocks directly. The advantage of direct stock ownership is that it allows investors to benefit from tax loss harvesting.
Loss harvesting involves selling selected investment positions at a loss and reinvesting the money back into the portfolio. These realized capital losses can then be used to offset capital gains from other investments – which reduces current taxes paid to the IRS. Natixis Investment Managers Solutions has specialized in tax loss harvesting since 2002.
Now let’s compare this approach to index funds and ETFs.
When you put them side by side, index funds, ETFs and direct indexing SMAs all seek to track an index on a pre-tax basis over time.
All will have about the same dividends and dividend taxes.
But the difference is that at the end of the year, the ETF or mutual fund may have zero capital gains, whereas the direct index may have net capital losses.
On an after-tax basis, index funds and ETFs will always underperform their pretax returns, due to taxes on the dividends. But with direct indexing SMAs, investors have the potential for higher returns after taxes, thanks to the ability to use tax loss harvesting.
Direct indexing from Natixis Investment Managers Solutions can help generate better returns because it lets investors keep more of their investment earnings after taxes.
Tax-efficient portfolios
Specialized portfolios
Sustainable/ESG indexing
Our proprietary methodology can apply environmental, social and governance (ESG) factors to create personalized indexes. Positive screening favors stocks with positive ESG ratings or that are best in class within their sector. Negative screening excludes specific securities or sectors based on an investor's preferences.
Frequently asked questions
Direct indexing is an equity investing strategy where individual stocks are purchased to create a portfolio that mirrors the performance of a preselected index, such as the S&P 500® Index. The goal is to outperform the index on an after-tax basis by employing tax management techniques including tax loss harvesting.
Direct indexing can potentially enhance after-tax returns through tax loss harvesting. This involves selling a stock when its value declines and substituting it with another security, allowing investors to record the loss for tax purposes.
Direct indexing can potentially be a good strategy for high-net-worth investors with significant gains, concentrated stock positions and complex tax situations.
Over the past three decades, we’ve helped high-net-worth investors generate after-tax alpha from our direct indexing solutions, successfully harvesting net losses for clients in 16 of the 17 upmarkets since 2003. Advisors have access to an experienced team and a service model that’s tailored to the high-touch needs of high-net-worth clients.
Since 2002, Natixis Investment Managers Solutions has provided fully customizable SMAs aligned to a variety of indices, spanning different market capitalization segments and geographic regions. We offer numerous strategies, including small-cap, mid-cap, large-cap and international.
Direct indexing using an SMA offers several benefits over index funds and ETFs, including the ability to customize portfolios to meet unique client needs and deliver tax savings through tax loss harvesting.
While both ETFs and direct indexing may help investors diversify their portfolios, direct indexing involves buying individual stocks that make up a specific index, whereas ETFs are a pooled investment security that holds multiple assets that track an index.
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Direct indexing solutions for tax-efficient diversification
Learn how a direct indexing strategy can help control the tax impact of diversifying a concentrated stock position.
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Create customized portfolios using direct indexing
See how index portfolios can be customized for ESG (environmental, social, and governance) or strategic investment goals using active screening techniques.
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Investment Risks: All securities are subject to risk, including possible loss of principal. Please read the risks associated with each investment prior to investing. Detailed overview of each investment's risks are included in Part 2A of the firm's respective Form ADV. The investments highlighted here may be subjected to certain additional risks.
A tax liability is the total amount of tax debt owed by an individual, corporation or other entity to a taxing authority.
Tax loss harvesting is a strategy for selling securities that have lost value in order to offset taxes on capital gains.
Capital gain is a rise in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price.
Investing involves risk, including the risk of loss.
Sustainable investing focuses on investments in companies that relate to certain sustainable development themes and demonstrate adherence to ESG practices; therefore, a portfolio’s universe of investments may be reduced. It may sell a security when it could be disadvantageous to do so or forgo opportunities in certain companies, industries, sectors or countries. This could have a negative impact on performance depending on whether such investments are in or out of favor.
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