How to Tell When Personalized Indexing Makes Sense: Vanguard

Clients enjoy choices when it comes to index investing. Index mutual funds and tax-efficient ETFs may be ideal for many, while others stand to benefit from the advantages, including tax-loss harvesting, available in direct, or personalized, indexing.

A personalized indexing portfolio, established in a separately managed account, or SMA, is tied to a benchmark index while allowing client customization. These accounts also offer opportunities to boost returns by selling certain holdings at a loss to reduce capital gains taxes, the Vanguard Group noted in a white paper posted this week.

How can a financial advisor tell which clients might be best suited to personalized indexing/?

The investing giant outlined four ways to tell who could most benefit from “improved after-tax alpha” via direct indexing, suggesting financial advisors seek clients in higher tax brackets with at least one of the following:

Significant, recurring, realized capital gains. This includes clients with active equity, private equity and other hedge-fund-like investments, and retirees taking distributions to meet spending needs.

Estate plans that anticipate charitable bequests or a step-up in basis. Gifting highly appreciated assets to charity from taxable accounts can lower taxes, as nonprofits don’t pay federal income tax on gifts, Vanguard noted.

Portfolios with highly appreciated assets, concentrated sector or style exposure. Look for clients who want to reduce a highly appreciated or concentrated position if they can offset taxes.

Meaningful new infusions into the investment portfolio throughout the investment period. Clients who do this may delay reaching the point where the portfolio contains no more stocks to sell at a loss.

Vanguard cited research showing that direct indexing with daily scans for tax-loss harvesting opportunities can increase after-tax alpha by at least 20 basis points for an investor with significant recurring capital gains.

“Direct indexing can help boost after-tax alpha for some, but not all, investors,” Vanguard said, explaining some clients might do better with traditional ETF and mutual fund strategies.

Among the factors advisors should consider when deciding whether to recommend direct indexing for a client, Vanguard cites:

• The frequency and size of recurring capital gains, and the extent to which tax-loss harvesting in taxable accounts can offset those gains.
• The expected alpha to be generated from owning preferred tax-inefficient investments, such as actively managed equities and private equity, in taxable accounts.
• The client’s capital gains tax rate and how costs compare between a direct indexing strategy and index mutual funds or ETFs.

There’s no one-size-fits-all recommended allocation for personalized indexing, Vanguard added.

The firm is one of many offering direct indexing, an area that has gained momentum in recent years.