Getting Beyond the Direct Indexing Hype | Part 2: The Tax Alpha Advantage

Summary

In a recent discussion among wealth management firms, tax management emerged as a primary concern, particularly through systematic loss harvesting. Advisors highlighted the increasing demand for customized portfolios that reflect individual values, such as ESG considerations. Direct indexing offers substantial after-tax performance advantages, with an annual increase of 100-150 basis points over benchmarks. The conversation also explored the potential for customization in fixed income portfolios. Engaging clients in the customization process is essential for meeting their unique financial circumstances and preferences, paving the way for a more personalized investment experience.

Takeaways

• 😀 Tax management is a primary concern for wealth management firms when selecting direct indexing providers.
• 📊 Advisors emphasize the significance of tax transition issues, highlighting them as crucial in client portfolio management.
• 🔍 There is a growing interest in downside protection among advisors, driven by potential market corrections.
• 💡 Systematic loss harvesting is essential for maximizing after-tax performance and is a foundational component of direct indexing.
• 📈 Parametric's systematic approach can lead to after-tax performance exceeding benchmarks by 100-150 basis points annually.
• 🗓️ Continuous monitoring throughout the year allows for opportunistic loss harvesting, alleviating year-end pressure for advisors.
• 🌱 Responsible investing is a significant trend, with clients seeking personalized portfolios aligned with their values.
• 🤝 Parametric collaborates with clients to create bespoke investment screens, addressing unique social issues such as human trafficking.
• 🏦 Direct indexing is applicable not only in equity markets but also in fixed income, allowing for similar customization.
• 🔗 Custom fixed income portfolios can be tax-managed and designed to meet specific client needs, reflecting the dual advantage of market capture and customization.

Q & A

What were the main customization needs identified by sponsors in the direct indexing provider survey?

The main customization needs included tax management, tax transition issues, interest in downside protection, and the ability to create thematic portfolios or exclude certain industry sectors.

How does Parametric approach tax management for clients?

Parametric employs active and systematic tax management techniques, including continuous loss harvesting throughout the year to optimize after-tax returns.

What is 'tax alpha,' and how significant is its impact on portfolio performance?

'Tax alpha' refers to the additional return generated through tax management strategies, such as loss harvesting. It can enhance after-tax performance by an average of 150 basis points per annum over long periods.

What is loss harvesting, and why is it important?

Loss harvesting involves selling securities that have declined in value to realize losses, which can offset capital gains in a portfolio. It is essential for enhancing tax efficiency and overall returns.

How does direct indexing benefit responsible investing?

Direct indexing allows for personalized investment strategies that align with individual values, enabling clients to create bespoke ESG portfolios that reflect their ethical preferences.

Can you provide an example of a unique customization offered by Parametric in responsible investing?

One example is a human trafficking screen developed in collaboration with a client, which has since been made available to other clients, allowing for targeted investments that combat human trafficking.

What types of fixed income portfolios does Parametric create?

Parametric offers custom core direct indexing portfolios and rules-based fixed income portfolios, such as laddered portfolios that systematically invest across the maturity spectrum.

How do fixed income portfolios incorporate customization and tax management?

Fixed income portfolios can be customized based on client needs and can also employ tax management strategies, similar to equity portfolios, to optimize after-tax returns.

What are some of the challenges faced by advisors when it comes to tax management?

Advisors often struggle with timely loss harvesting, particularly at year-end, and may find it challenging to maintain a comprehensive strategy throughout the year without systematic support.

Why is it important for portfolios to track alongside the market while also providing tax benefits?

Tracking alongside the market ensures that the portfolio captures broad market returns, while tax benefits from strategies like loss harvesting enhance overall performance and investor satisfaction.