Model Portfolio & SMA Strategists Showcase - Flipbook - Page 32
SMAs & MODEL PORTFOLIOS
WATCH OUT FOR
The harvest benefit
tapers
Early-year tax-loss harvesting can offset
roughly 2% of capital gains annually in a
new direct-indexed account. That benefit
shrinks over time as fewer losses remain
available to harvest. A strategy’s earlyyear tax-alpha numbers don’t necessarily
hold steady. Ask how the benefit has
trended as the account has matured.
or mutual fund, the investor directly
owns a diversified portfolio of individual
stocks within a separately managed
account. That direct ownership
is what makes tax management
possible at the individual-security level:
systematically harvesting capital losses
throughout the year to offset capital
gains, potentially reducing taxes paid
and enhancing after-tax returns, while
keeping more capital invested and
compounding through tax deferral.
A fund can’t do this for an individual
investor, because the fund’s trading
decisions apply to the whole pool
of shareholders at once, not to any
one investor’s specific tax situation.
Because SMA investors own individual
securities directly, capital gains deferral
is possible in a way mutual funds can’t
replicate. Mutual funds pass capital
gains through to shareholders even
if those shareholders haven’t sold
anything, while an SMA doesn’t trigger
a taxable event unless a trade actually
happens in that specific account. That
single structural difference is the entire
foundation of the “after-tax alpha”
thesis this chapter is built around.
HOW BIG THIS HAS ACTUALLY
GOTTEN
This isn’t a boutique strategy anymore.
Assets in tax-managed SMAs reached
more than $500 billion in 2024, up
67% from just two years earlier, and
direct indexing specifically is projected
to grow at roughly 12.3% annually,
reaching an estimated $825 billion in
total assets by the end of 2026.
pullbacks than during a steady, lowvolatility bull run, simply because
harvesting a loss requires a position to
actually be at a loss at some point.
Direct indexing SMAs in particular have
grown roughly 37% annually over the
past three years, a growth rate that
outpaces almost every other segment
covered in this guide, and one driven
directly by advisors’ and clients’
recognition that after-tax outcomes,
not just gross returns, are the metric
that actually determines wealth
accumulation.
This isn’t just an industry talking
point. Academic research specifically
evaluating tax-loss-harvesting alpha,
notably Chaudhuri, Burnham, and Lo’s
2020 study in the Financial Analysts
Journal, has found measurable,
quantifiable benefit from systematic
harvesting, independent of any single
provider’s own performance claims.
That’s worth knowing when a manager
cites a tax-alpha figure. There’s
genuine peer-reviewed research behind
the general concept, separate from
whatever specific number any individual
provider is showing in their own
marketing materials, and it’s fair to ask
a manager whether their own reported
figures are consistent with that broader
academic literature or an outlier from it.
TURNOVER, NAME COUNT, AND
WHERE TAX DRAG ACTUALLY
LIVES
An earlier chapter introduced the idea
that after-tax performance depends
heavily on turnover and portfolio name
count, not just pre-tax return (p. 31).
This is the chapter where that idea
becomes actionable. Research on
the tax cost of active management,
most notably the foundational Jeffrey
and Arnott work on this subject, has
consistently found that taxes are
often the largest single source of
portfolio-management inefficiency,
larger than fees in many cases, and
that the magnitude of that drag varies
enormously depending on turnover and
the number of distinct positions held.
A high-turnover, concentrated strategy
generates frequent, often short-term
capital gains that get taxed at the least
favorable rate. A lower-turnover strategy
with a larger number of individual
holdings gives active tax management
much more room to work.
This is also why market conditions
matter to the tax-management story
in a way that’s easy to overlook. A
strategy will tend to capture more
loss-harvesting opportunities, and
therefore generate a larger tax benefit,
during choppier markets with periodic
32
PERSONALIZATION
BEYOND TAXES
Direct indexing’s individual-security
ownership structure enables more
than tax management. It allows for
customization to tailor portfolios in a
number of ways to suit specific client
preferences and needs, and providers
routinely use this same infrastructure to
exclude specific sectors, companies,
or industries a client wants to avoid,
for personal values reasons, employerrelated restrictions, or concentration
concerns.
Direct indexing offers the flexibility to
exclude specific sectors or companies,
align portfolios with personal values,
and unwind concentrated positions
without compromising overall
diversification, a capability that will
come up again directly in the portfolio
transitions chapter’s discussion of
moving a concentrated stock position
into a diversified portfolio without
triggering an unnecessary tax bill (p. 36).
