Generate better after-tax returns with direct indexing

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  • 01 mins 59 secs
Learn why direct indexing with a separately managed account (SMA) is more tax-efficient than an index fund or ETF.
Channel: Natixis Investment Managers

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Index mutual funds and ETFs are reasonably tax-efficient, but investors must still pay taxes on their dividends and periodic capital gain distributions. For tax-sensitive investors, there may be a better way to index, using direct indexing through a separately managed account, also known as an SMA.

Direct indexing using an SMA has several distinct benefits over index funds and ETFs. It can still provide diversified stock exposure, but instead of holding a single position in a mutual fund or ETF, investors own perhaps hundreds of the underlying stocks directly. The advantage of direct stock ownership is that it allows investors to benefit from tax loss harvesting

Loss harvesting involves selling selected investment positions at a loss, and reinvesting the money back into the portfolio. These realized capital losses can then be used to offset capital gains from other investments – which reduces current taxes paid to the IRS. Active Index Advisors has specialized in tax loss harvesting since 2002.

Now let’s compare this approach to index funds and ETFs.

When you put them side-by-side, index funds, ETFs and direct indexing SMAs all seek to track an index on a pre-tax basis over time.

All will have about the same dividends and dividend taxes.

But the difference is that at the end of the year, the ETF or mutual fund may have zero capital gains, whereas the direct index may have net capital losses.

On an after-tax basis, index funds and ETFs will always underperform their pre-tax returns, due to taxes on the dividends. But with direct indexing SMAs, investors have the potential for higher returns after taxes, thanks to the ability to use tax loss harvesting.




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