It’s not 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 like index funds and 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 works
Direct indexing is an equity investing strategy wherein individual stocks are purchased to create a portfolio that mirrors the performance of a pre-selected index, such as the S&P 500® Index. The primary objective is to replicate the performance on a pre-tax 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
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 pre-tax 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.
Direct indexing separately managed accounts (SMAs) can be customized for tax purposes, to align with investor values and concerns, to tilt toward factors, or for a combination of objectives. All accounts are actively managed and provide beta exposure to equities while systematically harvesting investment losses that can be used to offset taxable gains in other parts of the portfolio.
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.
Racial equity indexing
Designed to track the S&P 500® index reasonably closely pretax, but with a deliberate focus on racial equity and justice. Invests in companies that are leaders in diversity, equity and inclusion, and avoids companies that cause, contribute to, exploit or profit from racial injustice.
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 pre-selected index, such as the S&P 500® Index.
Direct indexing can potentially be a good strategy for high-net-worth investors with significant gains, concentrated stock positions and complex tax situations.
Since 2002, Natixis Investment Managers Solutions has provided fully customizable separately managed accounts (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 a separately managed account (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 exchange-traded funds (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.
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.
Investor education
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A tax liability is the total amount of tax debt owed by an individual, corporation or other entity to a taxing authority.
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 environmental, social and governance (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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