Displaying items by tag: taxes

About 14% of advisors are aware of and recommend direct indexing solutions to their clients which is the primary reason that its forecast to grow faster than ETFs over the next decade. In a recent article by Allen Roth of WealthLogic, he discusses the pros and cons of direct indexing and compares it to ETFs.

Direct indexing has many of the same characteristics as ETFs such as allowing exposure to broad categories and having low costs. However, it allows for greater customization that can allow for portfolios that are more tailored to a client’s needs. 

Another distinct  advantage of direct indexing are that it allows for tax-loss harvesting which can offset capital gains. This strategy can allow for an additional 0.2 to 1% of returns and is more beneficial in down years. 

In terms of disadvantages, many of the most popular ETFs have less costs than direct indexing. For example, the most popular S&P 500 ETFs have annual expenses of 0.03%, while most direct indexing fees are in the 0.4% range. 

While this won’t make a different in the near-term, it will matter in the long-term especially as tax-loss harvesting benefits erode over time. Additionally, the slight tax benefits may be outweighed by the tax complications as each trade needs to be accounted for.

Finsum: Direct indexing is expected to grow at a faster rate than ETFs over the next decade. Yet for many investors, ETF remain the better choice.

A recent article from Morningstar’s John Rekenthaler discussed the tax benefits of direct indexing. Direct indexing is a strategy that involves directly buying the stocks of an index rather than through a fund. 

This confers several benefits such as allowing investors to gain the benefits of indexing while still being able to customize their portfolio to reflect their values and better fit their needs. Due to this, the category has exploded and gone from a niche offering solely for high net-worth investors to being offered by retail brokerages to customers for as little as $5,000.

However, the strategy is not necessarily for everyone, but it can be particularly useful for those with sizeable assets due to the potential tax benefits. This is because direct indexing results in capital losses in a separate account when stocks drop below their cost bases. The proceeds are then re-invested in stocks with similar profiles. 

This strategy can be particularly useful for investors with high federal and state taxes, large amounts of money invested in direct indexing vs other investments, short-term capital gains, and dealing with a volatile market environment. 

FinSum: Direct indexing comes with several benefits for clients but the most substantial one is the tax savings. However, it’s only worthwhile for a particular group of investors.

There is no question that investing in low-cost mutual funds or exchange-traded funds that mirror a benchmark index is a popular strategy to potentially reduce the impact of fees on a portfolio. In fact, many of these passive index strategies have often outperformed more costly actively managed funds. However, while tax efficient, they are unable to fully take advantage of short-term market volatility, according to Neale Ellis and Matthew Michaels of Fidelis Capital. On the other hand, direct indexing has become an attractive alternative to a portfolio of low-cost funds and ETFs, and unlike owning a mutual fund or ETF, an investor directly owns a basket of individual stocks that tracks a designated benchmark index. The strategy also allows greater flexibility during periods of volatility to selectively harvest losses while still closely tracking the benchmark. This is due to the fact that individual equities tend to see much higher volatility than a diversified mutual fund or ETF. This increases the opportunity for tax loss harvesting. Realizing losses in a portfolio can offset capital gains, which creates tax savings. Failing to harvest those losses during periods of short-term volatility could lead to lower results, essentially leaving money on the table.

Finsum:While passive index ETFs are tax efficient, they are unable to fully take advantage of short-term market volatility, which is something that direct indexing can do.

For decades, the wealthy have been able to see huge tax savings. Over one hundred years ago, investors could take tax deductions on wash sales, which involved selling a security at a loss and then buying back the same security. While Congress outlawed that technique in 1921, investment firms have continued to help billionaires save on taxes through other techniques such as tax-loss harvesting, which allows an investor to sell an investment for a loss and replace it with a reasonably similar investment. Direct indexing, which continues to gain steam among advisors, provides the perfect strategy to employ tax-loss harvesting. In a recent article, ProPublica authors Paul Kiel and Jeff Ernsthausen reported on the tax savings techniques of billionaires. The authors were able to reconstruct the tax-loss strategies of some of the nation’s wealthiest people using IRS data. For instance, they estimated that from 2014 through 2018, Goldman Sachs was able to generate tax savings of $138 million for Steve Ballmer, former CEO of Microsoft and current owner of the Los Angeles Clippers, without changing his investment portfolio in any meaningful way. In the year 2017, Ballmer’s direct indexing accounts posted over $100 million in tax losses through 15 loss-harvesting transactions, while the performance of the indexes it tracked, was way up. Tax records also show that Goldman Sachs routinely made trades for direct-indexing clients like Ballmer.

Finsum:Based on recent reporting by ProPublica, billionaires such as Steve Ballmer have been able to save billions through tax-loss harvesting in direct indexing accounts.

Model portfolios have been gaining ground with advisors. Close to $350 billion in assets sat in model portfolios as of March 2022, according to a Morningstar report in June. That’s a 22% increase over the prior nine months. But how do advisors incorporate model portfolios into their business? In a recent article, ThinkAdvisor asked different advisors how models fit in their practice. Erik Nero, founder, and president, of First Step Wealth Planning LLC, thinks they are a boost to small firms. He uses them for close to all of his clients except the client portfolios that need more customization. Kyle Simmons, lead financial planner, at Simmons Investment Management uses his own model portfolio but warns advisors not to get attached to models, as clients can come in with legacy holdings and tax consequences. Jan Pevzner, principal, of Gotham Block LLC finds models to be a great starting point for a “generic client” as it can save you a lot of time. Jon Ulin, CEO of Ulin & Co. Wealth Management uses models in addition to comprehensive planning for clients, which isn’t typically provided by robo-advisors. Nate Creviston, manager of wealth management and portfolio analysis, at Capital Advisors, does not use model portfolios at all as they lack tax awareness and believes each client deserves a customized portfolio unique to their needs and goals.

Finsum: With model portfolios gaining ground with advisors, ThinkAdvisor interviewed several advisors on how models fit or don’t fit into their practice.