Direct Indexing Tax Alpha

As direct indexing grows in popularity, we are increasingly asked about the potential tax benefits. Below is a brief overview:

Direct Indexing Basics

Before diving into the numbers, it is important to note that direct indexing does not produce a constant level of tax alpha. Tax alpha varies widely over time, both in individual years and over multi-decade time horizons. Excluding individual investor circumstances, the key drivers of direct indexing's tax alpha are:

Index returns
Index volatility
Dispersion of stock returns within the index

Additionally, there are two main sources of tax alpha over time:

A reduction in current year tax liability, as realized capital losses offset realized capital gains. Generally, we expect this benefit to be higher when index returns are lower, with higher volatility and dispersion. Conversely, we expect this benefit to be lower when index returns are higher, with lower volatility and dispersion. Under any scenario, we generally expect this benefit to be higher in earlier years and lower in later years.
The compounding of the above tax savings, which may continue to grow for years or decades.

Consider an investor who began direct indexing just before a major decline (say, in 1929 or 2007). The market decline would have provided plenty of tax-loss harvesting opportunities to reduce current year tax liability, but the investor would have lost a lot of money (since they invested just before a major decline). Alternatively, consider an investor who began direct indexing before a major rally (such as in 1932 or 2009). Although that investor would have had fewer opportunities to tax-loss harvest to reduce current year taxes, the portfolio would have done extremely well (since they invested before a major rally) and compounded any tax savings at a much higher rate (relative to the first example).

The Numbers

Recent academic research on the topic has corroborated what industry studies have been promoting for years. In short, annualized tax alpha can be as low as .86% (or .57% if the investor sells everything at the end of the period) or as high as 3.17% (or 2.29% if the investor sells everything at the end of the period). While both the independent and industry-funded studies reach similar conclusions, we encourage investors to consider the studies' assumptions relative to their personal situation.¹

Common Questions:

At what tax rate does it make sense to direct index?

Tax-loss harvesting will provide a tax benefit at any tax rate above 0%, although the benefit is larger for those in higher tax brackets. Similar to the analysis for other tax-advantaged strategies (such as retirement accounts), an investor's current tax rate is just one of many inputs. Other important questions include:

Will the stocks be sold at some point or gifted/bequeathed?
What will the investor's future income tax rate and/or estate tax rate be?
What is the growth rate of the assets and how much tax alpha will be realized?
Will capital be contributed or withdrawn from the strategy in the future?

There are many situations where we recommend direct indexing, but also many situations where we recommend against it. Unfortunately, there is no simple answer, so we recommend investors work with their advisors to determine whether direct indexing is best for their situation or not.

Does direct indexing make sense if I incur an additional cost for the service?

If the cost to direct index is higher than the alternative, then this marginal cost must be weighed against the potential benefits. Of course, the cost and benefits differ for each investor, so we encourage investors to work with their advisors to determine whether direct indexing is best for their situation or not.

The tax benefit for the first few years is great, but what about later years?

As mentioned above, there are two sources of tax alpha. However, many investors only focus on the first benefit. The reduction in current year tax liability is easy to see, measure, and accounts for the majority of tax alpha in the earlier years. However, the compounding of that benefit is rarely tracked by individual investors and is more difficult to measure, but may provide the majority of tax alpha over the long-term. Several years ago, Aperio published a paper delineating these two sources of tax alpha and illustrating the role of each in bull and bear markets.

Sources:

¹Chaudhuri, Burnham, & Lo; An Empirical Evaluation of Tax-Loss Harvesting Alpha, January 2020