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 major disagreements here—these points are well-made. There is also the possibility that a small account owner today may be looking at a sizable gain, which can be offset, or if expecting significant gains in the future, loss carryforwards can be a powerful tool for reducing their tax burden later on.

Compact DI's simplified structure, with fewer positions to manage, also reduces operational and trading costs compared to traditional direct indexing strategies and means that even smaller accounts can retain more alpha, preserving value over time. While direct indexing is more beneficial for larger accounts, smaller clients still stand to gain meaningful advantages, both now and in the future.