I'm Barry Retults, and on this episode of At the Money, we're going to discuss tax lost harvesting via direct indexent.
Effective tax policy.
Net migration of taxpayers at the upperanjust reduce taxes for everybody, wetting taxes for individuals and businesses tax tax. One of the most popular innovations of the past fifty years has been the tax qualified account. You know these is Boro one k's, IRA's Boro three b's. They've become more popular because you get to keep more of your net after tax returns. Savvy investors understand this. They maximize their tax
advantaged accounts. What about your taxable accounts? How can you maximize your net after tax equity returns from your non tax exempt portfolios. Well, some investors have turned to direct ind to do just that. They reduce the capital gains they pay on appreciated stock by improving their tax loss harvesting. I'm Barry Ridults and on today's edition of At the Money, we're going to discuss using direct indexing to maximize your
after tax net equity returns. To help us unpack all of this and what it means for your portfolio, let's bring in Ari Rosenbaum of O'Shaughnessy Asset Management, now a division of investing giant Franklin Templeton. Ari Rosenbaum, welcome to at the Money Barry.
Thanks so much for the opportunity to be here.
So before we get started, full disclosure, My firm Redults Wealth Management was one of the first clients to use O'Shaughnessy's direct indexing product Canvas. We currently have over a billion dollars on that platform. So I just want everybody to know disclosures out there. We never get in trouble by disclosing more rather than less. So Ari, for the late person, let's talk a little bit about direct indexing
and tax loss harvesting. For the typical non tax deferred account that maybe consists of a dozen mutual funds and ETFs, what does tax loss harvesting look like there?
Tax loss harvesting and a mutual funder in ETF would be done at the price of the funder. The ETF would be selling out of the entire position of the funder the ETF.
So, in other words, I have a dozen funds, one of them is doing poorly that year, I sell that funds. I replace it with a similar fund and capture that loss to offset my gains. How big of a harvest, how much taxes can I avoid through that method.
The challenge with that is that markets go up more often than they go down. Seventy five percent of years since the founding of the S and P. Five hundred, the market's actually up, and so the opportunities for harvesting in mutual funds or ETFs can be less because generally speaking, those strategies are going to be at a net gain.
So now let's look within the wrapper of the mutual funds or within the ETF. Tell us a little bit about direct indexing and how that allows us to access more of the losses that take place within those wrappers.
Great question. So the benefit of a mutual fund or an ETF is that you're getting a diversified portfolio and professional oversight, but again you've got that net gain generally over time. In a direct index you're getting that same professional oversight and diversification, but instead of investing in a product that's got one price, you've got access to the
individual securities underneath, all trading at different prices. In essence, you're getting a strategy that's very similar to say an S and P five hundred index or mutual fund, but you're investing in the individual constituents.
So in other words, I will own in a direct index product all five hundred of the S and P five hundred, Or let's take the Vanguard Total Market that's like twenty three hundred stocks something like that. You literally own all of those stocks individually.
A little bit less than that, say, probably three hundred, because many of those stocks had very very small positions in the S and P five hundred that really aren't meaningful to returns, so we for practical purposes remove those from the portfolio.
All right, what about a bigger index like the Vanguard Total Return Total market return?
Again similar, probably a few hundred stocks.
Okay, So now a typical year goes by and the mutual fund is up. So if you're holding the S and P five hundred, there may not be losses to harvest. But what if you're holding the three hundred companies within that index.
Historically, what we see in a large cat passive portfolio like that, year by year, about thirty six percent of the individual stocks are down, even if the index as a whole is up. In a fund or an ETF. Because it's up, you can't extract that for tax purposes. But in a direct index, you can get at those thirty six percent of stocks by selling those that are at a loss, maintaining the fidelity towards your overall investment strategy, and use those losses to offset gains over time.
So when I sell those individual companies, am I replacing them with something? Or am I just sitting in cash?
You're replacing them with stocks that have characteristics that are similar to the ones that you've sold out, so that you're keeping that underlying investment strategy similar to what you intended.
So it may not look exactly like the S and P five hundred, but mathematically it'll perform similarly. That's the expectation.
Very similarly.
So, if I'm managing tax loss harvesting with fifteen mutual fund ETF portfolio, the general rule of thumb is, hey, twenty twenty five basis points of your portfolio's gains can be offset with losses. What do those numbers look like if I'm holding a few hundred stocks instead.
So our research suggests that over a full market cycle, it would be more like about a half a percent to percent over time.
So fifty to one hundred basis points versus twenty to twenty five exactly. And I recall in the first quarter of twenty twenty, right as the pandemic ramped up, the S and P five hundred fell thirty four percent within that first quarter. It bottomed a few days before the quarter ended, and right as a typical tax lost harvesting and rebouncing took place. How did that quarter look for people invested in a direct indexing product like Canvas.
Yeah, we were doing a multiple of what we would have normally seen, so certainly after tax benefits north of three percent three hundred basis points over time, where we would have normally expected between fifty to one hundred.
So that's a huge number. I recall seeing some portfolios that were even more than that, four hundred four to fifty five hundred. Let's put this into context. Typically people take three years, five years, seven years, ten years to kind of work out of those positions and manage their tax obligations. How much can this accelerate that process and allow people to either diversify or cash out sooner than the typical route.
Yeah, I think that in this regard there's both a risk and a tax benefit. When you think about individual positions in stocks, our research actually suggests that most individual companies underperform the market, and do so with about twice the volatility over time. You had mentioned the pandemic. We actually have an investor that came to us shortly before the start of twenty twenty with about half of their net worth invested in low basis positions in a public
company for which they worked. And they were really emotionally invested in this particular position because they'd worked for the company and had done so well over time. They were also interested in finding ways to improve their risk and manage a taxable exit.
So in other words, they're trying to do two things. They want to diversify away from that concentrated position and at the same time not pay a giant tax bill, if you know, if it could.
Be avoided exactly right. So what they did was they brought the position to us. We actually built a risk aware exposure understanding that company's particular characteristics. We built a passive exposure to pair with the name that was underweight to similar companies, so that immediately their risk was mitigated because of that diversification. And then we started to look
for tax loss harvest opportunities. When there were losses in the market, we were able to take those losses and offset positions in the name, selling them down over time. We were actually able to do so in twenty twenty. Remember they started with a fifty percent position. We were able to reduce that to in a short period of time about a fifteen percent position net of any.
Gains, meaning they're not paying a long term or short term capital gains taxes on that exactly. And by the way, this isn't like I've jokingly described certain tax concepts as Wesley Snip's gray. You know, we don't know what the IRA. This is black letter law. The IRS is signed off on this. All of this is totally kosher and above board.
Yeah, the positions are at a gain, this particular concentrated position as a gain, we're able to take losses to offset that and work the position down over time. Now, in this instance, because the market movement was so significant to the down, we were able to do so in a very accelerated fashion. All within the context of that calendar year. They got down to about a fifteen percent
weight of the name. Remember they had started with fifty as a percentage of their total liver At that point, they decided to liquidate the entire position to move away from the risk exposure of that name, and they did so with a fraction of the tax consequence that had they sold out to begin with.
So this sounds like this is a sophisticated and expensive technology. What are the trading costs like this? How pricey is this?
So one of the things that's occurred in the market is that trading costs have dropped pretty dramatically.
Practically free at most custodians, right.
That's correct, that's correct. On our platform, the average fee a client is paying, as we've talked about basis points twenty one basis points, and so certainly with regard to many other options out there, when you're then adding the potential tax benefits on top on an after tax basis quite attractive.
I'd say, the very least. So is this for fat cats with millions and millions of dollars? Or is this for ordinary people? Can I do this?
Do I need?
Can I get into this with less than five million dollars.
Two hundred and fifty thousand dollars er minimum?
Okay, so not nothing, but not an unreasonable amount of dollars to do this. So to wrap up, if you're an investor sitting with a big pile of employee stock, option plan, equity, founder stock, venture, investment, startup, a sale of a business or a house, you're looking at a substantial capital gains tax. What matters most to you as an investor is your net after tax returns. Direct indexing is a really good way to allow you to keep
the most amount of your gains net of taxes. It takes some money, about a quarter million dollars invested in a taxable portfolio, but ultimately that can save you big dollars on your tax bill. You can listen to At the Money every week, finding in our master's and business feed at Apple Podcasts. Each week we'll be here to discuss the issues that matter most to you as an investor. I'm Barry Rittolts. You've been listening to At the Money on Bloomberg Radio.