How direct indexing can potentially enhance after-tax outcomes for high-net-worth investors.
Market volatility is typically viewed as a source of risk. For tax-aware investors, however, periods of volatility can also create opportunities.
Even when the broader market or an investor’s overall portfolio is rising, individual securities within that portfolio can experience very different outcomes. Some stocks may appreciate significantly while others decline below their purchase price. This dispersion can create opportunities to realize losses for tax purposes without necessarily changing the investor’s broader market exposure.
One increasingly sophisticated way to pursue these opportunities is through custom indexing.
What is custom indexing?
Instead of investing in an index such as the S&P 500 through a single exchange-traded fund (ETF), a custom-indexed portfolio owns a diversified basket of individual stocks designed to provide similar market exposure; this can accommodate investor-specific restrictions, preferences, or tax-management objectives.
This distinction can create an important tax-management advantage.
When an investor owns an ETF, the investor generally cannot sell an individual underlying company that has declined because the investor owns shares of the ETF rather than the individual securities.
With custom indexing, an investor may directly own hundreds of individual positions. Even when the overall portfolio is performing well, some securities may be trading below their original purchase price.
Positive portfolio performance and tax-loss-harvesting opportunities can exist at the same time.
Those positions can potentially be sold to realize capital losses, with the proceeds reinvested into replacement securities selected to account for wash-sale restrictions while seeking to maintain the portfolio’s desired market exposure.
In other words, positive portfolio performance and tax-loss-harvesting opportunities can coexist.
Consider a hypothetical investor with a $5 million taxable portfolio.
Suppose the overall portfolio has performed positively during the year, but market volatility has caused certain individual holdings to decline. Across the portfolio, assume approximately $250,000 of losses are available to be harvested. If appropriate for the investor’s circumstances, these realized losses could potentially be used to offset otherwise taxable capital gains.
The portfolio does not necessarily need to be down for tax-loss-harvesting opportunities to exist.
The resulting tax benefit will vary significantly based on the investor’s individual circumstances, including applicable tax rates, the character of realized gains and losses, existing tax-loss carryforwards, holding periods, and other tax considerations.
The important point is that the portfolio does not necessarily need to be down for tax-loss-harvesting opportunities to exist. Volatility among the individual securities can create opportunities beneath the portfolio-level return.
Tax-loss harvesting generally creates tax deferral rather than permanent tax elimination.
Selling an investment at a loss can reduce a current tax liability when that loss is appropriately used to offset realized gains. However, reinvesting the proceeds into a replacement security generally establishes a new cost basis. If that replacement investment subsequently appreciates, the investor may ultimately recognize a larger taxable gain in the future.
Deferring a tax liability may allow an investor to keep more capital invested for a longer period. When implemented effectively over time, this can potentially contribute to improved after-tax wealth accumulation after accounting for advisory fees, trading costs, taxes, and tracking differences, sometimes described as generating tax alpha.
Deferring a tax liability may allow an investor to keep more capital invested for a longer period.
The magnitude of that benefit depends heavily on the investor’s circumstances and how harvested losses are ultimately utilized.
Custom indexing can evolve from an investment strategy into a broader wealth-management tool.
For smaller taxable portfolios, the potential benefits of custom indexing may not justify the additional complexity.
For high-net-worth investors with several million dollars or more in taxable investments, however, portfolio-level tax management can become increasingly important.
The value can extend beyond tax-loss harvesting alone. Direct ownership of individual securities may provide greater flexibility to coordinate:
- Tax-loss harvesting
- Tax-lot management
- Capital-gain realization
- Portfolio withdrawals and liquidity needs
- Charitable gifting of appreciated securities
- Estate-planning considerations
- Portfolio-level tax management
This is where custom indexing can evolve from an investment strategy into a broader wealth-management tool.
Investment management should not operate in isolation.
For investors with substantial taxable wealth, investment decisions increasingly intersect with tax, estate, charitable, and liquidity planning.
Consider an investor who has substantial realized gains from the sale of a business, investment property, or another portfolio. Harvested investment losses may have different value for that investor than for someone without significant realized gains.
Similarly, securities with substantial unrealized appreciation may be candidates for charitable gifting rather than sale. Estate-planning decisions may also affect whether realizing gains or losses is appropriate.
The objective is to make investment and tax decisions within the context of the client’s overall financial circumstances.
These decisions illustrate why portfolio management should ideally be coordinated with the investor’s broader advisory team.
The objective should not be to harvest every available loss or minimize taxes at all costs. The objective is to make investment and tax decisions within the context of the client’s overall financial circumstances.
Focus on after-tax wealth creation—that’s the bigger picture.
Custom indexing is not appropriate for every investor, and tax considerations should never drive investment decisions at the expense of maintaining an appropriate investment strategy, diversification, or risk profile.
Custom indexing is not appropriate for every investor.
But for investors with substantial taxable assets, the ability to coordinate investment management with tax, estate, charitable, and liquidity planning can become an important component of a comprehensive wealth strategy.
At Baker Wealth Strategies, we work with high-net-worth clients and their professional advisors to evaluate whether custom indexing and other tax-aware portfolio strategies may be appropriate within the context of their broader wealth-management objectives. If you have a client who fits this profile, let’s talk.
Temitope Ayoola, CFA, FRM
Director of Investments
Baker Wealth Strategies
This material is provided for educational and informational purposes only and is not individualized tax, legal, or investment advice or a recommendation to buy or sell any security. Tax-loss harvesting does not eliminate taxes, may create future taxable gains, and is subject to limitations including wash-sale rules. Custom indexing may involve additional fees, trading activity, tax-reporting complexity, and tracking error relative to an index fund. The appropriateness and potential benefits of any strategy depend on an individual’s specific circumstances. There is no guarantee that tax-loss harvesting or custom indexing will result in a favorable tax outcome or outperform an alternative investment approach. Individuals should consult with their qualified tax and legal professionals regarding their circumstances. BWS Investment Management, LLC is a registered investment adviser. Registration does not imply a particular level of skill or training.
