Actively Tackling Taxes Through Passive Investing

We recently conducted a seminar titled “How to Powerlift Your Tax Alpha.” The seminar is available on our website, but I wanted our research team to provide some insight into exactly what we are doing to generate higher after-tax returns in client portfolios. Here’s what they had to say:

In order for active managers to outperform, they typically need to be pretty active, which means frequently buying and selling securities according to their outlook for future returns. Well, all that activity comes with a cost: taxes on short-and-long-term capital gains. Passive managers, meanwhile, tend to only buy and sell when there are changes in the underlying index they’re attempting to track, so they have many fewer transactions and many fewer realized gains.

How different is the level of trading between the two types of funds? Passive domestic equity funds often have turnover of around 5% a year. In contrast, actively managed funds experience a much higher degree of turnover, generally ranging from 20% on the low end to in excess of 100% or more on the high end! This turnover is usually the biggest determinant of a fund’s tax costs.

So what is the amount of tax drag you should generally expect from the funds you own? According to Morningstar, for the ten years ended December 2020, the average tax drag on domestic equity funds ranged from 1.55% per annum to 2.1% depending on the capitalization and style focus of the fund.

Since passive index-tracking funds usually have lower turnover than active funds, they tend to have fewer realized gains and hence a lower tax cost. And, exchange traded funds (ETFs) that track a particular index have additional efficiencies built into their structure that improve tax costs.

As we know, it can be very hard to outperform passive index funds on a pretax basis, and very, very hard to outperform them on an after-tax basis. However, while the tax costs of investing in passive index funds are relatively low, we observe that they still can result in meaningful tax drag. Fortunately, there is a way to capture the returns of a given index pretax, while actually exceeding the returns of the index after taxes, and that is through direct indexing.

What is direct indexing? It is holding all or a subset of the securities in an index via a separately managed account (SMA) in an attempt to track the returns of the index. In direct indexing just as in investing in an index-based fund or ETF, you attempt to track the returns of a given index prior to taxes and fees. But in contrast to funds and ETFs, direct indexing offers many more opportunities for tax loss generation, which we believe can lead to “tax alpha.”

What is meant by the term tax alpha, and how does direct indexing generate it? As we all have experienced, selling an investment that has increased in value can come with a meaningful negative tax impact. The flip side of this is that selling an asset that has declined in value comes with a positive tax benefit: a capital loss that can be used to offset gains the investor may have within their investment portfolio or elsewhere.

A direct indexing portfolio often holds hundreds of stocks, and as shown the chart below, in any given year there are stocks within an index that trade at a loss even when the broad market performs well.

2020 offered a great example of such a dynamic, where the broad S&P 500 Index was up nearly 20% for the year, but 35% of the names in the Index ended the year with a negative return.

In a direct indexing portfolio, trading to generate losses doesn’t occur at random. Again, the primary goal of a direct indexing strategy is to track a given index pre-tax which means that securities must be held that together replicate the characteristics of an index. When a security is sold to generate a loss, the portfolio manager will attempt to purchase a new security that maintains the overall portfolio’s similarities to the index. Meanwhile, stocks trading at a gain are usually not sold.

And what is the result? A well-managed direct indexing SMA portfolio will closely track the return of the market before the impact of taxes, but it will systematically generate realized capital losses at the same time.

The systematic harvesting of tax losses, when converted to a percentage return on the portfolio’s asset base, leads to a significant increase in the portfolio’s returns after taxes. The difference between the portfolio’s after-tax returns and pre-tax returns is what we call tax alpha.

Updated July 19, 2022