Direct Indexes vs. ETFs: Why Owning the Stocks Can Be More Tax Efficient

Why can a direct index be more tax efficient than an ETF?

A direct index lets you own the individual stocks in an index instead of a single fund that holds them. It lets you consider individual stocks and tax lots when deciding which gains or losses to realize. Whether that flexibility improves an after-tax outcome depends on your holdings, costs and applicable rules.

Indexing is our starting point. Index ETFs can provide broad exposure at low fund expense ratios. Direct ownership creates additional choices about individual holdings, but whether those choices improve an after-tax outcome depends on your account, implementation costs and tax circumstances.

Loss harvesting: an ETF moves as one unit

Take SPY, an ETF that tracks the S&P 500. You buy or sell shares of the fund, not selected stocks inside it. A sale can realize a loss if the ETF shares sold have an applicable tax basis above the sale proceeds. Different purchase lots can have different bases.

The difference is the level at which you can make investment decisions:

• When the fund rises, some underlying stocks can still fall. As an ETF shareholder, you cannot choose to sell just those individual stocks.
• When you sell ETF shares, you reduce exposure to the basket rather than choosing which underlying companies to sell.

With direct ownership, losses in individual stocks may create opportunities even when the group has risen. Suitable replacement holdings, wash-sale restrictions, trading costs and the effect on the portfolio all need consideration. More harvested losses do not automatically mean more tax saved.

A realized loss is not the same as tax savings

The amount of a realized loss is different from the resulting deduction, tax deferral or eventual tax benefit. A loss may not be usable immediately, and future gains, tax rates and costs can change its value. Comparisons of harvested losses should not be read as multiples of after-tax return or savings.

Gains deferral and portfolio risk

Gains deferral means considering which appreciated holdings to sell and when. It can change the timing of a tax liability, but retaining a position can also leave concentration or tracking risk.

Say you need to sell some U.S. large-cap holdings to raise cash or rebalance. Selling appreciated ETF shares may realize a gain, depending on the tax lots selected. With direct ownership, individual stocks may have different gains or losses, creating additional choices about which positions and lots to sell. The outcome depends on the holdings, applicable rules and portfolio constraints.

The trade-off is risk. You can't simply sell the stocks with the smallest gains if that would tilt the portfolio away from the index, so each sale has to weigh the tax savings against the effect on the portfolio's risk.

How we use this in Personal Index Portfolios

Our Personal Index Portfolios can replace the U.S. large-cap ETF with individual stocks while using low-cost ETFs for other exposures. Individual stocks have no fund expense ratio, but that does not mean the account has no costs. Actual fund expenses depend on the allocation and holdings, in addition to applicable advisory and optional charges.

For taxable accounts, active tax management is optional; Altruist, our custodian, charges up to 0.10% per year on enrolled assets, separate from our advisory fee. Integrity Financial Planning receives no part of it.

We discuss your existing gains, investment priorities and the trade-offs of changing holdings. Tax-loss harvesting requires attention to replacement holdings and wash-sale rules, including relevant trading outside the managed account; it cannot guarantee an allowable deduction or a particular tax outcome.

Clients who elect the service receive an annual estimated Taxes Saved or Deferred report prepared by Altruist. Estimates are based on assumptions, not proof of additional investment return.

Values-based exclusions are included in the advisory fee whether or not you choose tax management. Full terms are on our fees page.

For clients with assets under management under $500,000, the Advisor reserves the right to charge an hourly fee for financial planning.

When it matters most, and when it doesn't

Questions to review include:

• Is the account taxable, and can realized losses be used?
• How much has the existing portfolio appreciated, and what would a transition cost?
• How do tax rates, cash flows, outside holdings and portfolio size affect implementation?
• Do the potential benefits justify the additional complexity and costs?

It adds little tax value in IRAs and 401(k)s, where gains and losses aren't taxed each year. Harvesting opportunities also tend to shrink as a portfolio rises over time, and harvesting generally defers taxes rather than eliminating them.

Is a direct index right for you?

If you have a sizable taxable account, a concentrated position, or values you want reflected in your portfolio, a direct index may be worth a look. Todd Smurl, CFA, manages Personal Index Portfolios at Integrity Financial Planning, a fee-only fiduciary financial advisor in Houston. Schedule a free, no-obligation introductory meeting with Todd to discuss your current holdings, potential tax trade-offs and whether Personal Index Portfolios could fit.

See IRS Publication 550 for capital-loss and wash-sale rules.

This article is for educational purposes only and is not individualized investment, tax, or legal advice. Tax-loss harvesting does not guarantee a tax benefit, may defer rather than eliminate taxes, and is subject to the wash-sale rule. Investing involves risk, including the possible loss of principal. Full fee terms are in our Form ADV Part 2A.