Direct Indexes Are 3 to 5 Times More Tax Efficient Than ETFs
Direct indexes are three to five times more tax efficient than comparable ETFs. We’d like to explain why.
Guest post by Gerard Michael, President, Co-Founder Smartleaf, Inc
Loss Harvesting
Let’s start with loss harvesting. Consider SPY, an ETF that tracks the S&P 500. When you buy or sell SPY, you’re basically buying or selling a basket of 500 stocks. SPY goes up or down in value in sync with the average value of the stocks in the S&P 500. You can only loss harvest SPY if this average value goes down from where you bought it. This is clumsy. In up markets, some of those 500 stocks likely went down, but you can’t loss harvest them – you can’t call up the SPY people and ask them to sell just those stocks that went down relative to your purchase date. And in down markets, some of the stocks likely went up, but you still effectively have to include them in your sale.
In contrast, with a direct index, you can just sell the individual stocks that go down. This means you’re likely to be able to loss harvest even in an up market. And in a down market, it means you can loss harvest more, since you can choose not to sell the winners. Only in the extreme case where every stock in the S&P 500 goes down or every stock goes up will SPY be as efficient in loss harvesting as a direct index.
It makes a big difference. In our simulations (see footnotes for details), the direct index generated three times as much loss harvesting as an equivalent ETF with the same pre-tax returns. And in an upmarket, five times more.
Gains Deferral
Tax loss harvesting is only part of tax management. The other (actually more important) part is gains deferral – holding onto appreciated securities while still controlling the risk characteristics of the portfolio as a whole.
The explanation of why direct indexes are better than ETFs for gains deferral is similar to why direct indexes are better than ETFs for loss harvesting – only in reverse. Instead of trying to sell securities at a loss, we’re trying not to sell securities at a gain. And direct indexes make this easier. Suppose, for example, you need to sell some of your appreciated US large-cap holdings, either to withdraw cash or to rebalance the portfolio at an asset class level. If, as in our previous example, you own appreciated SPY, then any sale will result in realized capital gains. But if you own all 500 stocks in the S&P 500, it is likely that some went down (or at least appreciated a little) even though, on average, their value appreciated. This lets you select sales that minimize or even entirely avoid realized gains.
The tax superiority of direct indexes is not a new idea. What’s new is that the costs and the minimum account size for direct indexes have fallen dramatically, and direct indexes have become much easier to use. Driven by reduced (or zero) trading commissions, automated rebalancing analytics, and (in some cases) fractional shares, we’re seeing minimums fall by roughly a factor of 100, from $250,000 to $2,000, while costs have fallen more than half, from 35 - 45 bps to around 15 bps. And in a well-implemented system (like, ahem, ours), working with direct indexes is as easy as working with an ETF.
Over a ten-year period, index ETFs outperform something like 95% of investments. And direct indexes outperform index ETFs (on an expected after-tax basis).
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------