Speaker 1: I'm Barry Retults, and on this episode of At the Money,
Speaker 1: we're going to discuss tax lost harvesting via direct indexent.
Speaker 2: Effective tax policy.
Speaker 1: Net migration of taxpayers at the upperanjust reduce taxes for everybody,
Speaker 1: wetting taxes for individuals and businesses tax tax. One of
Speaker 1: the most popular innovations of the past fifty years has
Speaker 1: been the tax qualified account. You know these is Boro
Speaker 1: one k's, IRA's Boro three b's. They've become more popular
Speaker 1: because you get to keep more of your net after
Speaker 1: tax returns. Savvy investors understand this. They maximize their tax
Speaker 1: advantaged accounts. What about your taxable accounts? How can you
Speaker 1: maximize your net after tax equity returns from your non
Speaker 1: tax exempt portfolios. Well, some investors have turned to direct
Speaker 1: ind to do just that. They reduce the capital gains
Speaker 1: they pay on appreciated stock by improving their tax loss harvesting.
Speaker 1: I'm Barry Ridults and on today's edition of At the Money,
Speaker 1: we're going to discuss using direct indexing to maximize your
Speaker 1: after tax net equity returns. To help us unpack all
Speaker 1: of this and what it means for your portfolio, let's
Speaker 1: bring in Ari Rosenbaum of O'Shaughnessy Asset Management, now a
Speaker 1: division of investing giant Franklin Templeton. Ari Rosenbaum, welcome to
Speaker 1: at the Money Barry.
Speaker 2: Thanks so much for the opportunity to be here.
Speaker 1: So before we get started, full disclosure, My firm Redults
Speaker 1: Wealth Management was one of the first clients to use
Speaker 1: O'Shaughnessy's direct indexing product Canvas. We currently have over a
Speaker 1: billion dollars on that platform. So I just want everybody
Speaker 1: to know disclosures out there. We never get in trouble
Speaker 1: by disclosing more rather than less. So Ari, for the
Speaker 1: late person, let's talk a little bit about direct indexing
Speaker 1: and tax loss harvesting. For the typical non tax deferred
Speaker 1: account that maybe consists of a dozen mutual funds and ETFs,
Speaker 1: what does tax loss harvesting look like there?
Speaker 2: Tax loss harvesting and a mutual funder in ETF would
Speaker 2: be done at the price of the funder. The ETF
Speaker 2: would be selling out of the entire position of the
Speaker 2: funder the ETF.
Speaker 1: So, in other words, I have a dozen funds, one
Speaker 1: of them is doing poorly that year, I sell that funds.
Speaker 1: I replace it with a similar fund and capture that
Speaker 1: loss to offset my gains. How big of a harvest,
Speaker 1: how much taxes can I avoid through that method.
Speaker 2: The challenge with that is that markets go up more
Speaker 2: often than they go down. Seventy five percent of years
Speaker 2: since the founding of the S and P. Five hundred,
Speaker 2: the market's actually up, and so the opportunities for harvesting
Speaker 2: in mutual funds or ETFs can be less because generally speaking,
Speaker 2: those strategies are going to be at a net gain.
Speaker 1: So now let's look within the wrapper of the mutual
Speaker 1: funds or within the ETF. Tell us a little bit
Speaker 1: about direct indexing and how that allows us to access
Speaker 1: more of the losses that take place within those wrappers.
Speaker 2: Great question. So the benefit of a mutual fund or
Speaker 2: an ETF is that you're getting a diversified portfolio and
Speaker 2: professional oversight, but again you've got that net gain generally
Speaker 2: over time. In a direct index you're getting that same
Speaker 2: professional oversight and diversification, but instead of investing in a
Speaker 2: product that's got one price, you've got access to the
Speaker 2: individual securities underneath, all trading at different prices. In essence,
Speaker 2: you're getting a strategy that's very similar to say an
Speaker 2: S and P five hundred index or mutual fund, but
Speaker 2: you're investing in the individual constituents.
Speaker 1: So in other words, I will own in a direct
Speaker 1: index product all five hundred of the S and P
Speaker 1: five hundred, Or let's take the Vanguard Total Market that's
Speaker 1: like twenty three hundred stocks something like that. You literally
Speaker 1: own all of those stocks individually.
Speaker 2: A little bit less than that, say, probably three hundred,
Speaker 2: because many of those stocks had very very small positions
Speaker 2: in the S and P five hundred that really aren't
Speaker 2: meaningful to returns, so we for practical purposes remove those
Speaker 2: from the portfolio.
Speaker 1: All right, what about a bigger index like the Vanguard
Speaker 1: Total Return Total market return?
Speaker 2: Again similar, probably a few hundred stocks.
Speaker 1: Okay, So now a typical year goes by and the
Speaker 1: mutual fund is up. So if you're holding the S
Speaker 1: and P five hundred, there may not be losses to harvest.
Speaker 1: But what if you're holding the three hundred companies within
Speaker 1: that index.
Speaker 2: Historically, what we see in a large cat passive portfolio
Speaker 2: like that, year by year, about thirty six percent of
Speaker 2: the individual stocks are down, even if the index as
Speaker 2: a whole is up. In a fund or an ETF.
Speaker 2: Because it's up, you can't extract that for tax purposes.
Speaker 2: But in a direct index, you can get at those
Speaker 2: thirty six percent of stocks by selling those that are
Speaker 2: at a loss, maintaining the fidelity towards your overall investment strategy,
Speaker 2: and use those losses to offset gains over time.
Speaker 1: So when I sell those individual companies, am I replacing
Speaker 1: them with something? Or am I just sitting in cash?
Speaker 2: You're replacing them with stocks that have characteristics that are
Speaker 2: similar to the ones that you've sold out, so that
Speaker 2: you're keeping that underlying investment strategy similar to what you intended.
Speaker 1: So it may not look exactly like the S and
Speaker 1: P five hundred, but mathematically it'll perform similarly. That's the expectation.
Speaker 2: Very similarly.
Speaker 1: So, if I'm managing tax loss harvesting with fifteen mutual
Speaker 1: fund ETF portfolio, the general rule of thumb is, hey,
Speaker 1: twenty twenty five basis points of your portfolio's gains can
Speaker 1: be offset with losses. What do those numbers look like
Speaker 1: if I'm holding a few hundred stocks instead.
Speaker 2: So our research suggests that over a full market cycle,
Speaker 2: it would be more like about a half a percent
Speaker 2: to percent over time.
Speaker 1: So fifty to one hundred basis points versus twenty to
Speaker 1: twenty five exactly. And I recall in the first quarter
Speaker 1: of twenty twenty, right as the pandemic ramped up, the
Speaker 1: S and P five hundred fell thirty four percent within
Speaker 1: that first quarter. It bottomed a few days before the
Speaker 1: quarter ended, and right as a typical tax lost harvesting
Speaker 1: and rebouncing took place. How did that quarter look for
Speaker 1: people invested in a direct indexing product like Canvas.
Speaker 2: Yeah, we were doing a multiple of what we would
Speaker 2: have normally seen, so certainly after tax benefits north of
Speaker 2: three percent three hundred basis points over time, where we
Speaker 2: would have normally expected between fifty to one hundred.
Speaker 1: So that's a huge number. I recall seeing some portfolios
Speaker 1: that were even more than that, four hundred four to
Speaker 1: fifty five hundred. Let's put this into context. Typically people
Speaker 1: take three years, five years, seven years, ten years to
Speaker 1: kind of work out of those positions and manage their
Speaker 1: tax obligations. How much can this accelerate that process and
Speaker 1: allow people to either diversify or cash out sooner than
Speaker 1: the typical route.
Speaker 2: Yeah, I think that in this regard there's both a
Speaker 2: risk and a tax benefit. When you think about individual
Speaker 2: positions in stocks, our research actually suggests that most individual
Speaker 2: companies underperform the market, and do so with about twice
Speaker 2: the volatility over time. You had mentioned the pandemic. We
Speaker 2: actually have an investor that came to us shortly before
Speaker 2: the start of twenty twenty with about half of their
Speaker 2: net worth invested in low basis positions in a public
Speaker 2: company for which they worked. And they were really emotionally
Speaker 2: invested in this particular position because they'd worked for the
Speaker 2: company and had done so well over time. They were
Speaker 2: also interested in finding ways to improve their risk and
Speaker 2: manage a taxable exit.
Speaker 1: So in other words, they're trying to do two things.
Speaker 1: They want to diversify away from that concentrated position and
Speaker 1: at the same time not pay a giant tax bill,
Speaker 1: if you know, if it could.
Speaker 2: Be avoided exactly right. So what they did was they
Speaker 2: brought the position to us. We actually built a risk
Speaker 2: aware exposure understanding that company's particular characteristics. We built a
Speaker 2: passive exposure to pair with the name that was underweight
Speaker 2: to similar companies, so that immediately their risk was mitigated
Speaker 2: because of that diversification. And then we started to look
Speaker 2: for tax loss harvest opportunities. When there were losses in
Speaker 2: the market, we were able to take those losses and
Speaker 2: offset positions in the name, selling them down over time.
Speaker 2: We were actually able to do so in twenty twenty.
Speaker 2: Remember they started with a fifty percent position. We were
Speaker 2: able to reduce that to in a short period of
Speaker 2: time about a fifteen percent position net of any.
Speaker 1: Gains, meaning they're not paying a long term or short
Speaker 1: term capital gains taxes on that exactly. And by the way,
Speaker 1: this isn't like I've jokingly described certain tax concepts as
Speaker 1: Wesley Snip's gray. You know, we don't know what the IRA.
Speaker 1: This is black letter law. The IRS is signed off
Speaker 1: on this. All of this is totally kosher and above board.
Speaker 2: Yeah, the positions are at a gain, this particular concentrated
Speaker 2: position as a gain, we're able to take losses to
Speaker 2: offset that and work the position down over time. Now,
Speaker 2: in this instance, because the market movement was so significant
Speaker 2: to the down, we were able to do so in
Speaker 2: a very accelerated fashion. All within the context of that
Speaker 2: calendar year. They got down to about a fifteen percent
Speaker 2: weight of the name. Remember they had started with fifty
Speaker 2: as a percentage of their total liver At that point,
Speaker 2: they decided to liquidate the entire position to move away
Speaker 2: from the risk exposure of that name, and they did
Speaker 2: so with a fraction of the tax consequence that had
Speaker 2: they sold out to begin with.
Speaker 1: So this sounds like this is a sophisticated and expensive technology.
Speaker 1: What are the trading costs like this? How pricey is this?
Speaker 2: So one of the things that's occurred in the market
Speaker 2: is that trading costs have dropped pretty dramatically.
Speaker 1: Practically free at most custodians, right.
Speaker 2: That's correct, that's correct. On our platform, the average fee
Speaker 2: a client is paying, as we've talked about basis points
Speaker 2: twenty one basis points, and so certainly with regard to
Speaker 2: many other options out there, when you're then adding the
Speaker 2: potential tax benefits on top on an after tax basis
Speaker 2: quite attractive.
Speaker 1: I'd say, the very least. So is this for fat
Speaker 1: cats with millions and millions of dollars? Or is this
Speaker 1: for ordinary people? Can I do this?
Speaker 2: Do I need?
Speaker 1: Can I get into this with less than five million dollars.
Speaker 2: Two hundred and fifty thousand dollars er minimum?
Speaker 1: Okay, so not nothing, but not an unreasonable amount of
Speaker 1: dollars to do this. So to wrap up, if you're
Speaker 1: an investor sitting with a big pile of employee stock,
Speaker 1: option plan, equity, founder stock, venture, investment, startup, a sale
Speaker 1: of a business or a house, you're looking at a
Speaker 1: substantial capital gains tax. What matters most to you as
Speaker 1: an investor is your net after tax returns. Direct indexing
Speaker 1: is a really good way to allow you to keep
Speaker 1: the most amount of your gains net of taxes. It
Speaker 1: takes some money, about a quarter million dollars invested in
Speaker 1: a taxable portfolio, but ultimately that can save you big
Speaker 1: dollars on your tax bill. You can listen to At
Speaker 1: the Money every week, finding in our master's and business
Speaker 1: feed at Apple Podcasts. Each week we'll be here to
Speaker 1: discuss the issues that matter most to you as an investor.
Speaker 1: I'm Barry Rittolts. You've been listening to At the Money
Speaker 1: on Bloomberg Radio.