Tax Harvest Myths: Don’t direct index because… it creates too much change in the portfolio

Avatar photo by Ben Hood, CFA - VP, Portfolio Oversight

Key Takeaways

Direct indexing delivers the flexibility to customize portfolios and add value through automated tax-loss harvesting.

An unintended theoretical consequence of this flexibility could be a portfolio that no longer tracks its underlying index appropriately.

55ip’s platform delivers the benefits of automated tax-loss harvesting while maintaining appropriate index replication.

Solving the customization conundrum

One of the primary benefits of direct indexing is the ability to change, whether fundamentally or tactically, portfolios at the security level while replicating an underlying index. But whether we’re tailoring around other positions, screening for impact or fundamental criteria, or trading to realize tax losses, the degree of change, by definition, introduces differences in composition from the index. Thus, the potential for differences in risk and return, and therefore tracking error are also introduced.

Tracking error is a useful measure of the difference in performance between a portfolio and its benchmark index. Measured in percentage terms, it incorporates both over-performance and underperformance of the portfolio relative to its benchmark. It can be measured historically using realized returns, or, as in 55ip’s use case, it can be estimated on a forward-looking basis (ex ante tracking error) – predicting how different a portfolio’s returns might be from its benchmark due to differences in current positioning.

And herein lies the challenge. Investors seeking index-like returns should of course expect index-like returns – and risk. Yet customization and flexibility are potentially powerful benefits of direct indexing. The ability to continually tax-loss harvest throughout the year can certainly add value to portfolios, while filters such as ESG preferences can align them with investor values.

The concern that frequent, automated tax-loss harvesting can create large differences in holdings and therefore large differences in performance is theoretically valid (and would have been more valid in the past when the process was manual and imprecise.) How then do investors create a “best fit” between direct indexing flexibility while still appropriately replicating an index? As is often the case today, technology plays an important part.

Delivering the “best fit”: Guardrails between tracking error and tax benefits

Today, the balance between managing portfolio differences from the index and the benefits of tax-loss harvesting can be constantly measured and effectively balanced. The sophisticated ongoing analysis needed was once the bastion of institutional investors. It’s now been democratized.

Index replication for tax-smart portfolios that use the S&P500 as their benchmark typically involves about 350 stocks, not 500. It’s essential though, the portfolio’s risk profile not just be established, but also maintained. A simple model could keep similar overall sector weights to the index despite not owning every security. 55ip utilizes a more sophisticated factor risk model to continually monitor and optimize the portfolio’s profile against that of its index.

Using fewer stocks to replicate an index provides an important advantage. Losses can be harvested by replacing positions with other stocks (or baskets of other stocks) in the same industry sector or with similar risk characteristics. As a result, the portfolio can maintain a similar risk-return profile.

And when it comes to tracking error, the name itself is a misnomer in our tax-loss harvesting use case – we’re tracking the expected impact of deliberate portfolio differences. Here, tracking error is not erroneous – and when carefully controlled for, enables us to tax-loss harvest without undue impact on the portfolio itself.

The right automation tech doesn’t just scan security returns for harvesting opportunities. It can manage the portfolio level risk-return profile to monitor and control tracking error. Today, the tracking guardrails can be defined by the portfolio’s manager, continually monitored and easily adhered to.   

A quick addendum – the same principle also applies to utilizing tax-loss harvesting in ETF and mutual fund model portfolios. Although tax-optimized model portfolios have less granular exposures for potential tax-loss harvesting, continual and automated evaluation of both opportunity and tracking error has the same potential to improve after-tax investor outcomes.

The result for direct-indexed portfolios: Even with ongoing, automated tax-loss harvesting the tracking error and risk-return characteristics of the portfolio can be accurately monitored and effectively managed. The frequency and breadth of opportunities are increased, and meaningful differentiation delivered. 

55ip: Balancing tax-smart sophistication with simplicity

Automated tax-loss harvesting has the potential to deliver significant after-tax benefits. With 55ip, the benefits of continual tax-loss harvesting are balanced and optimized with ongoing portfolio monitoring. Advisors are empowered with a simple user experience and a sophisticated tax-smart engine to differentiate their offering, manage risk, and help their clients keep more of what their portfolios earn.

The expansion of tax-loss harvesting from an end of year or infrequent ad-hoc manual process to an automated, fully integrated and risk-managed function is here.

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