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Analyzing Tax Strategies Using Direct Indexing and ETFs
Limiting capital gains and taking tactical capital losses are strategies available to U.S.-domiciled investors to potentially reduce tax liability.1
We compared the tax implications of a hypothetical buy-and-hold ETF strategy benchmarked to the MSCI USA Index versus a buy-and-hold direct-indexing strategy tracking the same index.2 Both had three-year holding periods.
The ETF strategy did not realize any capital gains over our analysis period (2009 to 2022) because periodic rebalancing was not required to reduce tracking error versus the index.3 The ETF vehicle shielded the investor from capital gains incurred during ETF rebalancing.4 The direct-indexing strategy, which held individual equity positions, realized capital gains at each rebalance.
Two sides of the tax-efficiency coin
Based on the goal of minimizing realized capital gains, in our analysis the ETF strategy outperformed direct indexing: zero realized capital gains versus realized capital gains ranging from 0.15% to 4.7% of initial portfolio value each year.
For some clients, tax efficiency may also mean generating a capital loss to offset a realized capital gain to reduce tax liability. Direct indexing is increasingly being used for this purpose.5
We extended our analysis with the goal of harvesting capital losses while, for the direct-indexing strategy, minimizing tracking error to the benchmark.6 The ETF strategy did not realize any capital losses because opportunities to do so could trigger a wash sale.7
Direct indexing and ETFs can both play a part in designing a tax-efficient investment strategy informed by the client’s investment preferences and risk tolerance. Wealth managers may use ETFs to minimize taxes with little tracking error, whereas they may look to direct indexing to generate taxable losses at the cost of increased tracking error.
Compared to direct indexing, the ETF strategy realized no capital gains...
... but generated no realized losses.
1 A U.S.-domiciled investor is subject to the U.S. tax code, which includes the wash-sale rule and the ability to net realized capital gains against realized capital losses to reduce the taxpayer’s tax liability. Other jurisdictions may have different treatments for taxable gains and losses. For all references to laws, rules or regulations, please note that the information is provided “as is” and does not constitute legal or tax advice or any binding interpretation. Any approach to comply with regulatory or policy initiatives should be discussed with your own legal counsel and/or the relevant competent authority, as needed.
2 The strategies were funded with cash and rebalanced quarterly to minimize tracking error. They had no other constraints. Both the direct-indexing and ETF strategies were held for three years from their dates of inception. Inception date begins January 1 of each year. Data is from 2009 to 2022. On average, the direct-indexing strategies held between 350 and 550 stocks. We assumed no transaction costs. We used the MSCI Barra® US Total Equity Market Model for Long-term Investors (USSLOW) and the Barra® Open Optimizer.
3 An ETF has an implicit tax efficiency due to a redemption process that allows ETF managers to deliver shares “in kind” to authorized participants when requested. This facility does not trigger a capital gain and it lowers operational costs. “Why Are ETFs So Tax Efficient?” etf.com, accessed Oct. 2, 2023.
4 The investor may still incur taxable income through dividend payments, which are predictable for the ETF, but require individual management for the direct index.
5 “The Case for Direct Indexing: Differentiation in a Competitive Marketplace,” Cerulli Associates, accessed Oct. 2, 2023.
6 Under the tax-loss-harvesting scenario, the direct-indexing strategy maximized realized capital losses. We assumed no pre-existing tax liabilities.
7 If a U.S.-domiciled investor sold their ETF position, purchasing a substantially similar asset within 30 days after the sale would trigger the wash-sale rule and they would be unable to use the capital loss to offset realized capital gains. Other taxing jurisdictions may have different rules.
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