A Possible Solution for Concentrated Stock Positions
Taxes can create a major performance drag on any investment portfolio, but they’re especially harmful to concentrated equity portfolios. Fortunately, there are steps you can take to reduce the tax exposure of your concentrated stock position. One such strategy is referred to as enhanced direct indexing.
What is direct indexing?
Before we get into the “enhanced” part of this strategy, let’s define direct indexing. Direct indexing refers to the process of replicating an index, such as the S&P 500, by buying a smaller set of individual stocks at the same proportional weighting. Doing so allows an investor to maintain a diversified portfolio but with a fewer number of stocks than the overall index.
There are two main benefits of this approach:
- Avoiding adding to concentrated positions – Direct indexing allows investors with highly concentrated stock positions to avoid buying more of that position. For example, if you work at Procter & Gamble (P&G) and have a significant amount of P&G stock in your employer-sponsored retirement plan, you probably don’t want to purchase additional P&G shares by investing in an overall index, such as the S&P 500 or Dow Jones index. Direct indexing allows you to select a subset of individual stocks that doesn’t include P&G.
- Tax-loss harvesting – Direct indexing provides an opportunity to generate additional tax efficiencies through tax-loss harvesting, which involves selling an investment that has declined in value in the short term and replacing it with a highly correlated alternative. Take the S&P 500, for example, which has historically shown returns of approximately 8%-9% per year. However, at the individual stock level, an average of 150 of the stocks in the index (a full 30% of the index) lose 10% or more in value in any given year. This individual positioning allows for additional tax-loss harvesting.
What is enhanced direct indexing?
Enhanced direct indexing aims to provide upside exposure to equity market returns and potentially offset gains from taxable events. Put simply, the strategy has the potential to more efficiently build wealth, regardless of how the market is performing.
Let’s consider an example to illustrate how enhanced direct indexing works.
The image above shows an illustrative comparison of two $100 investments, one using a conventional tax-aware strategy and the other using enhanced direct indexing.
Investor A invests $100 using a standard direct indexing approach. This equals $100 of net market exposure that fluctuates according to the movement of the underlying investments.
Using an enhanced approach, Investor B takes both a long and short position alongside the $100 investment, resulting in $145 long and $45 short. Doing so provides the investor with $100 of net market exposure and $90 of active extensions. Investor B has the same net market exposure as Investor A but with the benefit of additional dollars at work in pursuit of excess returns and potential capital losses (i.e., tax benefits). Because the enhanced approach has both long and short exposure, Investor B can realize losses regardless of whether the market goes up or down.
When compared to other tax-aware equity investments, such as ETFs and tax-loss harvesting strategies, an enhanced direct indexing approach has the potential to offer after-tax outcomes that are larger, more consistent and longer lasting. That’s because it provides greater opportunity to capitalize on both positive and negative movements in the stock price. It also offers additional opportunities to defer capital gains and realize capital losses.
Direct indexing versus enhanced direct indexing
The chart above provides a hypothetical analysis of direct indexing versus enhanced direct indexing across various 10-year periods. Notice how the benefits of enhanced direct indexing are longer lasting than the standard direct indexing approach.
The chart below illustrates that, when compared to standard direct indexing, enhanced direct indexing allows investors to access losses, regardless of market direction.
Who benefits from enhanced direct indexing?
Due to the complexity of this strategy, enhanced direct indexing is only appropriate for high-net-worth investors with $10 million or more in investable assets. Typically, investors best suited for this strategy:
- Are facing a large taxable event, such as a business sale, inherited retirement account, deferred compensation payout, etc., and need to access capital losses in order to reduce their tax exposure.
- Are tied up in a highly concentrated stock position and need to start unwinding that position in order to reduce portfolio risk.
