A correspondent asks how we address concerns about direct indexes becoming “ossified”.
I was recently asked how we’d address questions or concerns about direct indexes becoming locked up (the idea that after a few years, the extra loss harvesting opportunities provided by direct indexes dry up, leaving the direct index with no further opportunities to be more tax efficient than a comparable ETF). Here’s my response:
Strictly speaking, if someone objected to direct indexing, we’d start by qualifying that our purpose isn’t to be an advocate; it’s to make direct indexes available and operationally simple, if and when clients need/want them. We’d also note that, independent of taxes, direct indexes are more customizable — you can apply social and religious value screens, counterbalance a client’s outside risk exposures (e.g. employment, stock grants, etc) by underweighting correlated securities in the index, tilt towards favored sectors, etc.
That being said, here’s how we’d respond to the specific concern that direct indexes aren’t valuable because they ossify.
Relative to comparable ETFs, direct indexes enable you to:
1. do more upfront loss harvesting. At a minimum, this is a form of tax deferral — essentially an interest-free loan — and under reasonable assumptions, this alone pays for the slightly higher costs of a direct index relative to an ETF.
2. transition legacy equity holdings (much) more tax efficiently. In our tests, we see transitioning a typical legacy equity book to direct indexes cuts taxes by more than 95% (from one 7% of portfolio value to under 0.3%) relative to simple liquidation.
3. implement cash withdrawals more tax efficiently. Whenever you sell ETFs, you’re effectively selling the underlying basket pro rata. With direct indexes, you can choose to preferentially sell securities with lower gains. This lowers your taxes, and this is true even if your direct index is “ossified” in the sense of no longer supporting loss harvesting.
maximize the tax value of charitable donations of appreciated securities. This is the inverse of making cash withdrawals more tax efficiently. Instead of selling the least appreciated securities, you donate the most appreciated securities. In this way you take maximum advantage of the effective step-up in basis when you donate appreciated securities.
4. implement rebalancing more tax efficiently. This is related to the previous point about direct indexes being more tax efficient with cash withdrawals. It’s a clumsy process with ETFs, a surgical one with direct indexes. We can illustrate this with an example:
Suppose you wish to sell large-caps and buy mid-caps. If you sold a large-cap ETF, then, as noted above, you’re effectively selling the underlying basket pro rata. This will potentially result in large realized gains. It also involves the largely pointless selling of small large-caps (which are basically mid-caps) and buying large mid-caps (which are basically large-caps). With a large-cap direct index, you can avoid the small large-cap → large mid-cap trade, and, more importantly, preferentially sell securities with lower gains.
These low-gain securities may, of course, be correlated — perhaps in the same sector or industry. That’s OK, because with direct indexes you can preferentially buy back mid-caps in the same sector/industry. This allows you to lower taxes while still maintaining your desired asset allocation, sector distribution, industry distribution, etc., and this is true even if your direct index is “ossified” in the sense of no longer supporting loss harvesting.
This sort of precision is not possible when selling a large-cap ETF and buying a mid-cap ETF. This same logic applies not just to asset class rebalancing, but any effort to change factor tilts.
The core underlying issue here is that the question about lock in implicitly equates “tax value” with “continued loss harvesting”. They’re not the same, both because past loss harvesting, even if it was in the past, is still valuable (you got an interest-free loan), and because there’s more to managing a portfolio than simply buying and holding. There’s transition, there are withdrawals, there are charitable donations, and there is rebalancing — all of which are more tax efficient with a direct index. Even if it is “locked in”.