When investors think of indexing, they typically think of mutual funds or ETFs that provide broad market exposure in a tax-efficient and low-cost manner. As the industry has evolved over time, so too has indexing, moving from tax-efficient one-size-fits-all investments to tax-managed customized strategies, otherwise known as direct indexing. In these portfolios managers purchase a basket of individual strategies that closely resemble the exposure and performance of the index they are trying to replicate.

Even though direct indexing has been available to institutional investors for decades, the higher minimum account size required to create a custom index portfolio made these types of strategies unattainable for most investors. Alongside the democratization of indexing as an investment methodology, technological advancements and decreased trading costs have now made direct indexing a viable option. With improved accessibility for individual investors through separately managed accounts and lower minimums, these customized strategies provide similar benefits as index funds and ETFs, but with greater control and tax efficiency.

Layers to Customization
Buying individual securities enables the flexibility to tailor portfolios to the unique needs of each client. Accounts can be customized to exclude an individual security, industry or sector, create a factor tilt, or align with a client’s values through an ESG screen. By employing these techniques, investors can maintain diversified exposure while targeting portfolios to specific goals. Meanwhile, advisors can coordinate investment activity across the portfolio to try to avoid unexpected tax outcomes.

Active Tax Loss Harvesting
By relying on direct indexing to provide core, multi-factor, or ESG exposure, investors can attempt to avoid some of the pitfalls of commingled funds. As investors move in and out of mutual funds or ETFs, or as managers change positions, investors can find themselves with unexpected taxable distributions. Direct indexing with separately managed accounts puts control back in the hands of the advisor and investor so that they can manage taxable events through the use of active tax-loss harvesting techniques.

Direct indexing is also distinct from using a model portfolio, and with good reason. For example, while two model portfolios may both have positions in Apple, each portfolio was created at a different time. As a result, the purchase prices for stocks that make up each individual’s portfolio are going to be different. From a tax management perspective, the entry point establishes the cost basis and determines whether the position is at a gain or loss. A robust tax management overlay factors in the cost basis for each position at the tax lot level. Model portfolios don’t allow for that level of tax awareness because they cannot differentiate unrealized gains and losses by account.

By constructing a direct index, which is usually made up of a subset of stocks tailored toward a specific outcome, the portfolio manager can incorporate active tax-loss harvesting into the investment process. Such active tax management can control the maximum realized gains specified by an investor, perhaps limiting them to only realized losses. In some cases, there may be net realized losses instead, which can be valuable in offsetting gains outside the portfolio or in future years. This may allow investors to defer taxes on capital gains, and potentially increase after-tax returns.

Custom Index Portfolios Help Improve After-Tax Returns

Less Taxing Transitions

Direct indexing can also help portfolios that are in transition. Advisors may have prospects or clients with existing stock portfolios, and the only way to transfer these assets may be to liquidate them. But this could result in a sizable capital gain and a large tax bill. Instead of liquidating the positions, they can be moved into a direct index portfolio and transitioned over time using a capital gains budget that could reduce or defer capital gains completely. This could potentially increase investors’ willingness to bring more assets to their advisor to manage.

Greater After-Tax Return Potential
Ultimately, direct indexing gives financial professionals another tool for crafting innovative portfolios that solve for acute needs, be that the desire for investment customization or improved tax management. A direct index strategy can also work alongside existing, traditional components of a portfolio and aid the reallocation process over time. This puts a considerable level of control back in the hands of the financial professional and the investor to be able to alter portfolios and try to avoid unexpected taxable distributions. Over time, investors may also realize a higher rate of after-tax returns due to active tax management techniques – allowing them to keep more of what they earn.
All 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 the universe of investments may be limited and investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. This could have a negative impact on an investor’s overall performance depending on whether such investments are in or out of favor.

Natixis Advisors, L.P. does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions. This material is provided for informational purposes only and should not be construed as investment advice. There is no guarantee that objectives stated will be achieved. All securities are subject to risk, including possible loss of principal. Please read the risks associated with each investment prior to investing. Detailed discussions of each investment’s risks are included in Part 2A of each firm's respective Form ADV. References to performance are based on past performance, which is no guarantee of future results. This document may contain references to copyrights, indexes and trademarks that may not be registered in all jurisdictions. Third party registrations are the property of their respective owners and are not affiliated with Natixis Investment Managers or any of its related or affiliated companies (collectively “Natixis”). Such third party owners do not sponsor, endorse or participate in the provision of any Natixis services, funds or other financial products. Natixis Advisors, L.P. provides advisory services through its divisions Active Index Advisors® and Managed Portfolio Advisors®. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, LLC.