Direct Indexing: Passive Investment With Potential Tax Benefits

by: FTSE Russell

By Rolf Agather, managing director, Research

In the United States - and many other countries - investors are required to pay capital gains taxes on profits generated from their investments. Since US regulations require mutual funds and ETFs to pass any capital gains to shareholders annually, tax efficiency can be limited for these index vehicles. Separately managed accounts (SMAs) that fully replicate an index - thus providing a solution that can offer a tax benefit - have generally only been available for large investors. An innovative solution called Direct Indexing enables indexes to be passively tracked even in accounts with small balances.

Taxes are often a primary consideration for the taxable investor. In fact, a key driver behind the rise of ETFs is their tax efficiency relative to index mutual funds. Due to their unique structure, most ETFs are able to eliminate their capital gains to shareholders through the creation/redemption process where their index mutual fund peers often distribute an annual capital gain.

While ETFs can be more tax efficient than mutual funds, they are both limited in that they cannot pass-through capital losses to shareholders. SMAs have the potential to provide this additional tax benefit. SMAs follow a defined investment objective - like a mutual fund or ETF - but individual securities are owned directly in the investor's account.

Holding individual securities directly in the account facilitates tax loss harvesting on an individual security level, thereby offering the potential to offset other income that investors file on their annual tax return. However, to date, this type of fully replicated passive investing hasn't been available in SMAs for investors with smaller account balances.

Direct Indexing offers the following characteristics:

  • Tax advantaged. Investors may implement tax loss harvesting on individual stock positions.
  • Customizable. Investors may exclude investments due to concentrated, single-stock positions or avoid investing in certain ESG areas.
  • Holdings transparency. Account statements show individual securities owned and the number of shares/bonds of each security owned.

FTSE Russell has licensed its indexes to SMArtX Advisory, who maintains a Unified Managed Account (UMA) platform and has partnered with Black Diamond to provide performance reporting. Black Diamond recently hosted a webinar - with SMArtX and FTSE Russell participating - to discuss Direct Indexing and the ease of implementation and performance reporting on the Black Diamond/SMArtX platform.

The webinar highlighted the ease of building, rebalancing and managing Direct Indexing portfolios across hundreds of individual client accounts. It also discussed implementing tax loss harvesting through Direct Indexing and the simplicity of client reporting that rolls hundreds of individual stocks into a single line item on client performance reports. Watch my portion of the webinar presentation now.

We believe Direct Indexing in UMAs may be attractive to some investors. A UMA allows an investor to hold ETFs, mutual funds, individual securities and SMA strategies all in a single account. UMA implementation is executed by an overlay manager, or an investment manager whose sole purpose is to execute trades. UMA overlay managers that license FTSE Russell indexes can offer a FTSE Russell index to investors to be directly and fully replicated in portfolios with tax loss harvesting.

The chart below highlights the similarities and differences between Direct Indexing and ETFs.

Fractional share trading allows investors to implement Direct Indexing in their accounts using FTSE Russell's core US equity indexes - like the Russell 1000® Index - at very low account balances. The characteristics of fractional share trading are meaningful:

  • Low account minimums
  • Tracking error minimization
  • More index options
  • Easy portfolio management - withdraws/deposits and rebalancing

The chart below highlights the differences between fractional share trading and whole share trading for the Russell Top 200® Index (200 constituents) and the Russell 1000 Index (1000 constituents).

© 2018 London Stock Exchange Group plc and its applicable group undertakings (the "LSE Group"). The LSE Group includes (1) FTSE International Limited ("FTSE"), (2) Frank Russell Company ("Russell"), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, "FTSE GDCM"), (4) MTSNext Limited ("MTSNext"), (5) Mergent, Inc. ("Mergent"), (6) FTSE Fixed Income LLC ("FTSE FI") and (7) The Yield Book Inc ("YB"). All rights reserved.

FTSE Russell® is a trading name of FTSE, Russell, FTSE GDCM, MTS Next Limited, Mergent, FTSE FI and YB. "FTSE®", "Russell®", "FTSE Russell®", "MTS®", "FTSE4Good®", "ICB®", "Mergent®", "WorldBIG®", "USBIG®", "EuroBIG®", "AusBIG®", "The Yield Book®", and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE GDCM, Mergent, FTSE FI or YB. "TMX®" is a registered trademark of TSX Inc. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.

All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of the FTSE Russell Products or the fitness or suitability of the FTSE Russell Products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell Products is provided for information purposes only and is not a reliable indicator of future performance.

No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this communication or links to this communication or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.

No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this communication or accessible through FTSE Russell Products, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.

No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE GDCM, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.