Direct Indexing Goes Mainstream
Feb 14, 2024
Head of PGIM Custom Harvest, Robert Holderith, discusses higher interest in direct indexing and shares how tax-loss harvesting can help drive long-term wealth management success across market conditions.
BROAD OPPORTUNITIES FOR AFTER-TAX RETURN SEEKERS
Equity markets continued their recovery from the previous year’s lows in 2023. Investors cheered the headline numbers, but dispersion was high as the technology, communication services, and consumer discretionary sectors generated the bulk of the return. The remaining sectors have lagged the S&P 500, with some delivering negative returns. Once again, growth trounced value in this large-cap dominated market. But, over the past 2.5 years, many investor portfolios have struggled to deliver positive returns as performance was punctuated with a bear market in 2022.
These conditions appear to be driving higher interest in direct indexing. Designed to take advantage of volatility in its pursuit of index- topping after-tax returns, direct indexing has the potential to play a bigger role in investment management. It opens a broad set of options that provide investors more tax efficiency in their portfolios, offering unique benefits that can’t be replicated in a traditional ETF or mutual fund structure. The investment community is starting to recognize its appeal and, consequently, we believe direct indexing will continue to grow.
Frequency matters in optimizing tax-loss harvesting opportunities
Many investors think about tax-loss harvesting, direct indexing’s principal benefit, as a calendar-year strategy. They gather up all of the losses that can be found at the end of the year in order to help offset gains realized over the same period. But that approach alone likely doesn’t maximize tax-savings potential.
Direct indexing isn’t an end-of-year strategy. Losses can occur at any time during the year, and losses available at one point in the year may be gone before the year’s end. The potential for losses to prove fleeting highlights the importance of ongoing loss monitoring to maximize loss-harvesting opportunities. A direct indexing strategy that seeks to harvest losses on an intra- day basis can capture them when they’re available. Losses can then be used to offset gains realized in the current calendar year or carried into future years to offset gains incurred down the road.
Direct indexing isn’t an end-of-year strategy. Losses can occur at any time during the year, and losses available at one point in the year may be gone before the year’s end.
Capture tax benefits in up and down markets
Without question, the volatility in recent years has gotten people’s attention as has the ability of direct indexers to capture tax losses, which can translate into several thousands of dollars in potential federal tax savings. Add that to a muted pre-tax return and the after-tax return is quite attractive. Tax management could have taken some of the sting out and added value in a dismal market environment.
But the strategy doesn’t require a dramatic drawdown or negative index returns, to work, and its mandate isn’t to lose money. In general, its objective is to deliver performance aligned with an index on a pre-tax basis while outperforming it after taxes by harvesting losses that can be used to lower an investor’s overall tax liability.
More volatility and broader access to reap tax benefits
Looking ahead, there’s no reason to believe that intersector volatility won’t continue. Direct indexing stands ready to capitalize on it. Once limited to high-net-worth investors with extremely large investment portfolios, this investment strategy is now poised for broader adoption (technology improvements and lower transaction costs) and with it the potential to generate better outcomes for many more investors.1
1While all investors potentially can benefit from a direct indexing strategy, the value of tax losses and after-tax returns decrease as an investor’s tax rate decreases.
Risks—Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index
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