Direct Indexing: Understanding Potential Outcomes
The primary goal of direct indexing is to outperform a benchmark after taxes while tracking it before taxes. However, there are a number of other potential outcomes as shown in Figure 1. At any given time, an account may underperform, outperform, or track an index along two dimensions – before taxes and after taxes. In the short run, portfolio sampling, tax loss harvesting opportunities, index changes, market volatility, market direction, cash flows, dispersion, specific stock risk, or many other reasons may land an account in any of the boxes.
Direct indexing usually involves holding only a subset of the index. While full replication (holding all of the securities in the index) may enable very close tracking pre-tax, it may also significantly inhibit the ability to tax loss harvest and outperform after taxes. To outperform after taxes requires intentional deviation from the index. However, holding only a subset of the index may result in a portfolio landing in any of the rows above: outperforming, tracking, or underperforming the index.
During any given window of time, this could have a positive or negative impact, especially in the short term. However, portfolio construction and rebalancing are generally intended to trend toward the index over time, often referred to as reversion to the mean. In general, investing in equities should only be done if investors have a sufficiently long holding period to mitigate the risk of short-term losses. This is doubly true for direct indexing, where a sufficiently long holding period is necessary for mean reversion.
After Taxes: Outcomes Along the Horizontal Axis
If the market shoots up quickly upon inception of a direct indexing account, then outperforming (or even tracking) an index on an after-tax basis may not be mathematically feasible, resulting in one of the left column results. In such scenarios, there may not have been any depreciated securities to tax loss harvest, yet rebalancing activity may still be needed to keep the portfolio in line with the index. This could result in net gains being realized.
In the long run (over full market cycles, but generally over at least three years), the market and individual securities tend to have ups and downs. This creates opportunities to tax loss harvest and increases the chances of moving toward the center or right columns. But this outcome is not guaranteed, and in some cases, may become less likely if the portfolio appreciates sufficiently beyond cost basis. This is why it is more common to realize losses closer to inception than after the portfolio matures and appreciates.
Why Risk Direct Indexing?
Because relative performance before taxes is independent of relative performance after taxes, an account may land in any box during any given measured window. However, that doesn’t mean every outcome is equally likely to occur.
Since tracking error before taxes tends to mean revert over time, the expectation is that portfolio performance will end up closer to the center row the longer it is held. Meanwhile, tax loss harvesting tends to be more common closer to inception, but may decline over time. This often starts the portfolio in the center or right columns. When that does occur in the earlier years, the portfolio further benefits from compounding, even if tax loss harvesting diminishes later.
Not all markets exhibit this behavior, however. In some cases, market shocks or other events can flip the outcome considerably. For example, a portfolio initiated in January 2020 may have captured very large after-tax benefits from the market downturn in March 2020. But for a portfolio started post-crash in April 2020, the markets shot up very quickly. The subsequent 12 months had little to no loss harvesting opportunities, and may have required gains to be realized to manage tracking error risk. This could lead some to conclude that direct indexing doesn’t work. And indeed, they could be right, based on that specific window of time for that specific period in history.
The worst outcome is underperforming the index both before and after taxes. While direct indexing allows for the possibility of moving toward the center row and right column, that may not happen in all cases. Even so, there are a number of potential reasons to use direct indexing, despite the possibility of landing in an undesirable box.
Direct Indexing Benefits
The most common benefit of direct indexing is in tax planning, where using a taxable account can create the potential for many options including:
A second benefit that is growing in popularity is portfolio customization beyond what is available off the shelf. Nearly infinite combinations of restrictions and screens may be applied by security, groups of securities, sector, industry, country, environmental, social, governance, religious, or a host of factors to implement the desires of the account owner. Some restrictions may help reduce overlapping risk exposure, while others may be incorporated based on values or beliefs. The ability to customize portfolios extensively may offer greater utility than concerns about potential underperformance.
Direct indexing isn’t for everyone. Ultimately, investors need to be comfortable trading unknown tracking error risk with the possibility of outperformance after taxes. Regardless of outcome, direct indexing still allows for flexible tax planning and customization, which may alone justify its use.
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All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
Indexes are not investments, do not incur fees and expenses and are not professionally managed. It is not possible to invest directly in an index.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market or other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
Natixis Advisors, LLC provides advisory services through its division Natixis Investment Managers Solutions. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, LLC. Natixis Advisors, LLC does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decision.
Figure 1 – Potential Performance Outcomes of Direct Indexing Strategies
Direct indexing usually involves holding only a subset of the index. While full replication (holding all of the securities in the index) may enable very close tracking pre-tax, it may also significantly inhibit the ability to tax loss harvest and outperform after taxes. To outperform after taxes requires intentional deviation from the index. However, holding only a subset of the index may result in a portfolio landing in any of the rows above: outperforming, tracking, or underperforming the index.
During any given window of time, this could have a positive or negative impact, especially in the short term. However, portfolio construction and rebalancing are generally intended to trend toward the index over time, often referred to as reversion to the mean. In general, investing in equities should only be done if investors have a sufficiently long holding period to mitigate the risk of short-term losses. This is doubly true for direct indexing, where a sufficiently long holding period is necessary for mean reversion.
After Taxes: Outcomes Along the Horizontal Axis
If the market shoots up quickly upon inception of a direct indexing account, then outperforming (or even tracking) an index on an after-tax basis may not be mathematically feasible, resulting in one of the left column results. In such scenarios, there may not have been any depreciated securities to tax loss harvest, yet rebalancing activity may still be needed to keep the portfolio in line with the index. This could result in net gains being realized.
In the long run (over full market cycles, but generally over at least three years), the market and individual securities tend to have ups and downs. This creates opportunities to tax loss harvest and increases the chances of moving toward the center or right columns. But this outcome is not guaranteed, and in some cases, may become less likely if the portfolio appreciates sufficiently beyond cost basis. This is why it is more common to realize losses closer to inception than after the portfolio matures and appreciates.
Why Risk Direct Indexing?
Because relative performance before taxes is independent of relative performance after taxes, an account may land in any box during any given measured window. However, that doesn’t mean every outcome is equally likely to occur.
Since tracking error before taxes tends to mean revert over time, the expectation is that portfolio performance will end up closer to the center row the longer it is held. Meanwhile, tax loss harvesting tends to be more common closer to inception, but may decline over time. This often starts the portfolio in the center or right columns. When that does occur in the earlier years, the portfolio further benefits from compounding, even if tax loss harvesting diminishes later.
Not all markets exhibit this behavior, however. In some cases, market shocks or other events can flip the outcome considerably. For example, a portfolio initiated in January 2020 may have captured very large after-tax benefits from the market downturn in March 2020. But for a portfolio started post-crash in April 2020, the markets shot up very quickly. The subsequent 12 months had little to no loss harvesting opportunities, and may have required gains to be realized to manage tracking error risk. This could lead some to conclude that direct indexing doesn’t work. And indeed, they could be right, based on that specific window of time for that specific period in history.
The worst outcome is underperforming the index both before and after taxes. While direct indexing allows for the possibility of moving toward the center row and right column, that may not happen in all cases. Even so, there are a number of potential reasons to use direct indexing, despite the possibility of landing in an undesirable box.
Direct Indexing Benefits
The most common benefit of direct indexing is in tax planning, where using a taxable account can create the potential for many options including:
- Future tax loss harvesting
- Future gain deferral
- Application of gain budgets
- Charitable gifting strategies
- Estate planning
- Step-up in basis
- Transferring in/out specific tax lots
- Transitioning portfolios
A second benefit that is growing in popularity is portfolio customization beyond what is available off the shelf. Nearly infinite combinations of restrictions and screens may be applied by security, groups of securities, sector, industry, country, environmental, social, governance, religious, or a host of factors to implement the desires of the account owner. Some restrictions may help reduce overlapping risk exposure, while others may be incorporated based on values or beliefs. The ability to customize portfolios extensively may offer greater utility than concerns about potential underperformance.
Direct indexing isn’t for everyone. Ultimately, investors need to be comfortable trading unknown tracking error risk with the possibility of outperformance after taxes. Regardless of outcome, direct indexing still allows for flexible tax planning and customization, which may alone justify its use.
Download PDF
Indexes are not investments, do not incur fees and expenses and are not professionally managed. It is not possible to invest directly in an index.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market or other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
Natixis Advisors, LLC provides advisory services through its division Natixis Investment Managers Solutions. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, LLC. Natixis Advisors, LLC does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decision.
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