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Direct indexing seeks to closely track the performance of a market index while creating tax savings to increase returns in taxable accounts. The potential tax savings can offset capital gains anywhere in a taxable portfolio. Portfolios can be customized to reflect investors’ goals and values in taxable and non-taxable accounts. Investors own individual securities in a direct indexing portfolio via a separately managed account (“SMA”). Holding individual securities rather than a single fund is what allows investors to customize their exposure while providing greater tax efficiency. The direct index SMA can be funded with an existing portfolio of securities, including appreciated stock.
Direct indexing provides an enhanced ability to generate tax alpha, which optimizes after-tax returns. While alpha is a measure used to evaluate portfolio returns in excess of a benchmark index, tax alpha is a measure of after-tax account return that exceeds pre-tax return in excess of a benchmark. The example shown here illustrates the tax alpha that may be achieved by the growth of an initial investment over a 25-year period.
Proper tax management is especially important when exiting securities with appreciated gains. When transitioning securities into a Direct Index SMA, the account can be funded in-kind without creating a taxable event. The tax management tools available through direct indexing can be used to achieve a tax-efficient portfolio transition and potentially minimize, delay, or avoid net taxes.
Assumptions: Initial Investment Amount: $1 Million | Annualized Equity Market Return: 8% | Dividend Tax Rate: 23.80% | Long-Term Capital Gains Tax Rate: 23.80% | Short-Term Capital Gains Tax Rate: 40.80%. This sample provided does not reflect the investment results of actual securities and is not a guarantee of future results. Changes to the assumptions will drastically change the results. Chart Methodology: The sample provided assumes a starting basket of 300 equally-weighted hypothetical securities. Returns are randomly simulated monthly with the annualized mean chosen above and annualized standard deviation of 30%. It is assumed that the portfolio's 2% annualized dividend yield is subject to income tax and is reinvested monthly into a new tax lot. The "Passive" strategy simulates a buy-and-hold strategy over the investment horizon. The "Tax-Advantaged" strategy simulates a tax-loss harvesting strategy. In any period that a tax lot's cumulative loss exceeds 5%, the tax lot is sold, and the proceeds are immediately reinvested, plus any tax benefit, into a new tax lot. Tax benefit calculations assume that the capital gains offset by the harvested loss are 50% short-term and 50% long-term. The Monte Carlo simulation takes an average across 2000 iterations for each set of return, risk, and tax assumptions. The sample presented does not represent actual trading of securities and is not indicative of actual investment strategy performance. The impact of market factors is not included in this simulation which may cause the results to be over-or-under stated. This should not be construed as a representation that any account will, or is likely to, achieve profits, losses or tax savings similar to those reflected in this example.
First Trust Direct Indexing provides exposure to a variety of benchmarks through direct ownership of individual securities in a portfolio via a tax-advantaged SMA. These SMAs offer continual portfolio review with intra-day tax-loss harvesting to provide a greater ability to generate tax alpha. They can be customized based on factor tilts or personal values while keeping tracking error in line with a specified target.
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Investors can express their view through traditional factors, risk management strategies, or values-based investing. Our platform offers a vast amount of preset options to add or eliminate companies, industries and sectors. We also offer the ability to blend indexes and build custom solutions.