Can Direct Indexing Add Tax Alpha to Small Accounts?
Welcome to Part 3 of our ongoing response to Gerard Michael's and Brent Sullivan 💸's great conversation: “Do Direct Indexes Make Sense for Investors Under $1MM and Over $5MM?” In this blog post, we share our perspective on a key aspect of their discussion—can direct indexing add tax alpha to small accounts?
For those catching up, you can find our Part 1 response here: https://lnkd.in/gBjCEb2K
In it, we focused on the challenges investors face when holding a large number of positions and our proposed solution.Objection: Small/negative tax alpha
Response: Yes, the tax alpha for smaller accounts tends to be lower simply because the investor's marginal tax rates tend to be lower. But the tax alpha is still quite high. We looked at accounts that were invested 100% in direct indexes. For accounts greater than $1mm, 100% cumulatively over the life of the account saved or deferred more in taxes from active tax management than the advisor charged in fees. Below $100K, this number drops to 78%. This shows that, indeed, direct indexing is more valuable for larger clients. But 78% is still an impressive number. And, to be clear, it isn't that for 78% of accounts, taxes saved or deferred cumulatively made up for the management costs of the direct index. It's that for 78% of accounts, taxes saved or deferred cumulatively made up for all fees paid to the advisor. The tax alpha is not small.
One twist here is that small-account holders with low marginal tax rates sometimes "graduate" into becoming large-account holders with high marginal tax rates. In this case, loss harvesting and other forms of gains deferral that are at the heart of tax management can be said to backfire – you're effectively pushing gains taxes from a low to a high tax bracket. In practice, this is not a problem, even if it happens. It seems that most small investors are happy to exchange paying less tax when they're poorer for more tax when they're richer – the dollar value of the tax may be higher, but the pain it causes is lower.
GMAM's Response
There are no arguable points here—Jerry's analysis is well-reasoned. However, there’s an additional layer worth considering for smaller account holders: While their marginal tax rates may be lower today, they may face sizable gains in the future, where loss carryforwards from active tax management could be highly beneficial.
A few scenarios where this could play out include:
Unwinding a concentrated stock position: Investors may hold significant shares in a single company, whether inherited, accumulated through employment, or acquired through other means. As the investor seeks diversification, a direct indexing strategy that utilizes loss carryforwards can soften the tax hit from liquidating that position.
Liquidity needs or major capital events: Investors could also face a substantial capital gain from the sale of a business or an asset, prompting the need for careful tax management. Losses harvested early on can offset those gains, helping them manage taxes more efficiently during a life event or major liquidity need.
In these cases, loss harvesting in smaller accounts isn’t just about maximizing tax alpha in the present but about positioning the portfolio for long-term tax efficiency as the investor's wealth grows.
Beyond Tax Efficiency: Customization
Another overlooked advantage of direct indexing and separately managed accounts (SMAs) is the opportunity for personalization. Investors may have specific needs or preferences, whether those involve excluding certain securities, adhering to ESG, SRI, or faith-based guidelines, or navigating individual constraints like industry restrictions. Direct indexing offers a level of customization that traditional ETFs or mutual funds cannot match, making it a versatile tool for wealthier clients and smaller investors alike.
Compact DI’s Efficiency Advantage
(Commercial plug) Additionally, Compact DI’s streamlined structure inherently reduces the operational and trading costs associated with managing numerous positions, helping preserve more of the tax alpha even for smaller accounts, where efficiency is critical for optimizing returns.