Tax Harvest Myths: Don’t direct index because… tax-loss harvesting opportunities erode

Avatar photo by Hiren B. Patel, Head of Advisor Solutions

Key Takeaways

The value of direct indexing and tax-loss harvesting at the security level can be more significant and durable than some investors believe.

Continued dispersion of returns within an index can deliver significant benefits over time, even when overall market volatility is within historic norms.

Automated, disciplined tax-loss harvesting is the key to leveraging intra-year dispersion, unlocking additional benefits and delivering a differentiated client experience.

The Rise of Direct Indexing 

Direct indexing allows investors and advisors to build a portfolio with individual stocks that represent a chosen index by directly owning each security. Long viewed as an option for only high net worth investors, the strategy has gained broader appeal and growing market share with the development of new trading technology, fractional share investing and declining fees. 55ip’s automated, personalized tax-smart investing platform has been a leader in driving this change – continuing to break down the barriers to differentiated client experience and better investment outcomes.  

A Key Investor Concern can be Misplaced 

One of the biggest benefits of direct indexing – tax-loss harvesting – is also one of the key concerns of skeptics. If the market keeps going up, what’s the value of tax-loss harvesting even at the individual security level? Surely if we wait long enough nearly every stock in the index rises? Granted, time in the market is an investor’s best friend – only 11% of rolling 5-year periods are negative for the S&P 500, and over 10 years it’s 3 1/2%1. But the benefit of direct indexing is that we have the ability to look – and act – at the security level where the story (or more accurately, stories plural) can be very different.  By owning an index at the individual security level, the dispersion of stock returns within the index is the key determinant of the opportunity, and individual stock returns can differ greatly from the returns of the index itself.  

Significant Dispersion Exists Even in a Steady Market 

Past performance is, of course, no guarantee of future results. But even across long periods, just as some outperformers persist, so too can the indexes’ laggards. By May of this year the S&P was up 8% while the majority of stocks in the index were down – the median return for the year at that point was minus 0.2%2.  In 2022, 91% of the individual stocks in the S&P had loss-harvesting opportunities during the year3.  

Just this year, dispersion for the S&P climbed to 31% at the end of March, up from 23% in February and above the 75th percentile historically4. In July alone the S&P rose 3.1%, but the gap between the top and bottom performing stocks in the index was more than 55%5.  It’s the same story at the sector level. Year to date through July 31 the S&P was up more than 20%. The Technology sector was up 46.6% (and Communications Services 45.7%) while utilities fell 3.4%6.  

Even when broad markets and some individual sectors may be doing well, sectors don’t move in lockstep. Far from it. In March for example, regional banks experienced a pocket of significant but brief volatility. Overall, the S&P held its ground while fears of broader contagion dissipated, finishing up 3.5% for the month.  Not every underperformer is Worldcom, and not every dip is a crisis.  If you’re looking closely, harvesting opportunities are always ebbing and flowing, usually without headlines. 

And let’s not forget that annual and annualized numbers by definition obscure intra-year volatility. In 2020, the gap between the year’s bottom (down 34%) and it’s end of year return (up 16%) was 50%!6 Granted, this volatility can also be a benefit to harvesters owning the index at the single fund or ETF level, but it can exacerbate dispersion at stock and sector levels. 

FactSet, S&P Global, J.P. Morgan Asset Management
Aug, 2023

And How Realistic is the “Buy and Permanently Hold” Scenario Anyway? 

The premise of eroding opportunity is largely based on a specific application of “buy and hold.” That is, if a lump sum is invested on a specific date, even the laggards eventually generate a positive return… or leave the index. But in practice that’s perhaps a very narrow use case.  Whether dollar cost averaging, making ad-hoc investments or automatically reinvesting dividends, many investors are adding to their portfolios throughout sometimes lengthy accumulation phases – and often beyond.  

Each new purchase represents a new entry point into each of the stocks in the index – with a resetting of the “dispersion clock” for that reinvestment. Should the previous period’s laggards reverse course, new laggards emerge and the opportunities for harvesting continue even if the names change. 

But even for the most extreme “buy and permanently hold” investor the benefits of tax-loss harvesting can also be applied to decumulation. Direct indexers have greater control over when to pay embedded gains by utilizing security level gains and losses into their selling discipline. They can, for example, delay the sale of stocks with higher gains to reduce (albeit not eliminate) realized gains or pass the highest gains to their heirs with a step up in cost basis. 

55ip’s Technology Changes the Harvesting Calculus 

Granted, this could get complicated. Different entry points into single stock positions means there’s a lot to keep track of. But what was once an occasional, manual and laborious task for advisors is now easily automatable. Sophisticated, tax-smart portfolios are within the grasp of advisors seeking to differentiate their offering and for investors seeking better after-tax returns. 

Because tax-loss harvesting no longer needs to be a ‘one and done’ end of year transaction, intra-year volatility combined with automated tax-loss harvesting has the potential to augment and extend opportunity. The more frequent the scans, the greater the sum of the opportunities can be.  

By partnering with 55ip, advisors are empowered with a simple user experience and investment strategy engine for model delivery including design, selection, tax-smart transition and automated trading that help optimize time and value to prioritize what matters most – clients.  

Footnotes

1 S&P/lazyportfolioetf.com 

2 CNBC 

3 Russell Investments 

4 S&P Global. Dispersion is the annualized, index-weighted standard deviation of the index constituents’ full month total returns.  

5 S&P Global 

6 JP Morgan Asset Management Guide to the Markets 

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