Assets and Taxes - How Direct Indexing Can LOWER Your Tax Bill! | Episode #4

Starting point is 00:00:00 Are you looking to keep more of what you earn while still benefiting from market returns? Whether you're an experienced investor or new to the concept, direct indexing can provide the tax advantages you need for long-term financial success. Welcome back to another episode of Assets and Taxes. I'm Dave O'Brien, Senior Consultant here at Asset Strategy. Today, I had the opportunity to sit down with Jeff Murphy, market leader for New England at Invesco, to talk about direct indexing and how it's transforming tax-efficient investing. We explored the key benefits of tax-loss harvesting. We also touched on the advanced use of leverage and shorting to continue harvesting losses even during upward-trending markets,

Starting point is 00:00:41 a game-changer for investors in bull markets. Ready to optimize your tax situation while keeping your portfolio aligned with the markets? Whether you're looking to reduce capital gains taxes or better manage your wealth, Asset Strategy can help you tailor a strategy that fits your needs. Book a discovery call with us today. Let's find the right solutions tailored to your needs. So without further ado, here's Assets and Taxes. Hi, welcome to Assets and Taxes. I'm Dave O'Brien, Senior Consultant with Asset Strategy. Joining me today is Jeff Murphy,

Starting point is 00:01:25 Market Leader for New England with Invesco. Today, we're talking about direct indexing. So Jeff, welcome. Why don't you tell us a little bit about yourself and Invesco? Yeah, thanks. Thanks, Dave, for having me. It's a pleasure being here this morning. And yeah, I've been with Invesco for going on seven years, been in the industry for close to 20. And what we do at Invesco is strictly we're an asset manager. So we manage roughly $1.7 trillion, and that's across stocks, bonds, alternatives, cash management. Great. Wow. $1.7 trillion. That's pretty impressive. Now, people may be familiar with index investing, right? So you follow the S&P 500, Dow Jones,

Starting point is 00:02:19 Russell 2000. There's a lot of indexes out there. I think it started back in the 70s with Jack Bogle founded Vanguard and invented the first index mutual fund. So indexing isn't new, but this concept of direct indexing seems to have really taken off in, I'd say, maybe the last 10 years or so. Now, what exactly is direct indexing? Direct indexing is when we're buying a group of stocks to replicate an index. So let's say the S&P 500 over time stocks are going to go up stocks going to go down we look at those stocks that go down we sell those stocks and we buy similar stocks now in doing so we harvest a loss that we can use as an asset to offset gains and we're at the same time we're buying similar

Starting point is 00:03:05 stocks so we're still participating in the market so we're getting market like returns along with tax alpha okay so what we're thinking about is so through the course of a calendar year or just over time there's a lot of dispersion within different stocks in that index, right? So you're taking those losses along the way. You're banking those, right? So you can harvest those losses. We did a blog post on this recently, what we called making lemonade out of those investment lemons, right? So what's the benefit, though, to the end investor? Why do we do that? What's the point? The point is reducing capital gains taxes and deferring that tax liability to compound growth over time.

Starting point is 00:03:58 So in direct indexing, we're controlling the controllables, right? Passive has grown dramatically over the years because it's very efficient market, the U.S. large cap market. You know, the 20 analysts on Wall Street follow Apple. How much value is that 21st analyst providing to the community to buy and sell Apple stock, for example? So the performance of the index has outperformed active managers in this space over the past 10 years. So people want passive exposure to U.S. large cap, but they want to control those controllables. And that's their tax benefit that they would get from direct indexing. Got it. So it's the old adage, it's not necessarily what you make, it's what you keep, right? So if I can reduce my tax drag,

Starting point is 00:04:52 my net return as the investor is going to be enhanced, right? That's the idea? Okay. So we talked a little bit about tax lost harvesting. But what happens there? I understand. So over time, right, the market tends to go up over time. We can't predict the future. We're sitting here at near all time highs, you know, in recent time recently on at least the S&P 500. And, you know, at some point, don't you run out of losses to harvest?

Starting point is 00:05:24 Yeah, good point, Dave. And that's one thing we take a look at with direct indexing, because over time, stocks tend to go up, generally speaking. And it's getting harder and harder for us to harvest losses as upward trending markets take hold into a bull market. So in that case, we are essentially waiting for a market pullback, some sort of market volatility to create opportunities for us to harvest losses. Or if the client can add cash to the account, that enables us to harvest some losses as well. Got it. So you start out with new basis, as we say. So if you put in some new money into an account, you're starting out with new basis. That gives you kind of a reset button, right? So you can have new losses there. But ultimately, at the end of the day, people are investing for a future goal, right? They want to use this money for something. So when they do go to take money out of the account, hopefully those gains that they would have are offset by these losses we've kind of banked along the way.

Starting point is 00:06:31 That's exactly right. We think of those investment losses as an asset. It's a tax asset that we can use to offset those future gains. And I would add, too, it's not just about offsetting those capital gains taxes in the future. We also pay very close attention to which tax rates that we're paying, right? There's short-term tax rates. There's long-term capital gains tax rates. There's qualified dividends.

Starting point is 00:06:58 There's non-qualified dividends. And they all have different time frames that we're keeping an eye on. And that's one way we mitigate the tax liability as well. Got it. So and one of the things that can be sort of a disadvantage of a mutual fund structure is you may get a capital gains distribution at the end of the year because they have to pay those out if they have gains within the portfolio. So you may have gains in other parts of your overall portfolio you could use these losses to offset other gains right that's right okay got it so it's important to note though this is not something you would

Starting point is 00:07:34 do inside of an IRA or tax advantaged account this is really just for people with taxable investment assets right non qualified accounts where the tax man is at play, that's the best. So tax-deferred accounts, like you mentioned, traditional IRAs, Roth IRAs, any kind of qualified accounts, maybe think about doing a different strategy within those. Got it. And so now there are a little bit more sophisticated ways. We talked about sort of just a plain vanilla tax loss harvesting where you own a basket of stocks that replicates the index.

Starting point is 00:08:10 You harvest those losses along the way, invest in a similar security. So we need to avoid what's called the wash sale rule. Talk a little bit about what is a wash sale and why does that matter? Yeah, if you sell a stock, you can't recognize that loss if you go back into it within 31 days. And so that's another time period that we keep a close eye on. So we're going to be selling a stock, banking the loss, locking that in, realizing that loss, that's an asset for us. And then at the same time, we'll buy a similar stock with similar characteristics. So it could be in the same time, we'll buy a similar stock with similar characteristics. So it could be in the same sector, same industry. So we can still participate on the appreciation on the upside. Got it. So we're not necessarily timing the market, but there are anomalies like

Starting point is 00:08:56 we talked about. I used the example of Lowe's and Home Depot, right? So Lowe's has a bad earnings report. They maybe take a big hit. You sell it, take the loss, and you buy Home Depot. You're still exposed to the sector. The next 30 days or so, let's say, you know, Home Depot and Lowe's both do similarly well if the market's kind of going up. So we're participating. But there is sort of this dispersion or what we call tracking error. Talk a little bit about that and how you try to

Starting point is 00:09:25 manage around not being way off from the index performance-wise. Yeah, it's a great question, Dave. It's all about balance, right? We want to track the index as closely as possible, but we still need that wiggle room, right? We can't have all 500 stocks within the S&P 500. We're going to have a good number but we need those stocks that are on the sidelines on the bench that when those stocks that we own sell sell off we can sell those and then get some of those bench names into the index so we'll track the index closely it won't be perfect we talk about tracking error which is something that we measure. It's how far

Starting point is 00:10:05 off of the index that we are. And we're looking to be about 1% tracking error. In other words, 1% off of the index. And that wiggle room allows us to still track the index as close to as possible, but still have the balance of increasing the tax benefit. Got it. So say the S&P 500 is up 10% on a given year, you're going to be up plus or minus maybe nine, maybe 11, something like that. That's kind of the goal. In that neighborhood. Got it. Got it. Sometimes might be a bit ahead, might be a little behind, but with that tax alpha, the net returns over time will likely make up for any tracking error, right? Correct. And again, it goes back to controlling the controllables.

Starting point is 00:10:46 We feel like if we can get investors very similar returns to the index, but improve their tax situation, that's a win. Got it. Now, I guess that brings me back to this, you know, in the last 10 years or so, it seems like everybody, Invesco and others, have these direct indexing strategies, and they're getting a lot more attention. I think just technology-wise and trading, the cost of trading, you probably couldn't have really done this that long ago. If you're paying commissions and bid-ask spreads are really wide, it probably logistically wouldn't have been very doable, right? So talk to me a little bit about technology and how that's evolved and how that's enhanced these strategies. Yeah, great point, Dave. Technology has come so far in this space.

Starting point is 00:11:36 The software that we have is really second to none. It's something that we've invested a lot in, and it allows us to manage tens of thousands of accounts very similarly. So it allows us to replicate the index in a very scientific way, very methodical way. And then when we see stocks that sell off, the portfolio managers come into their desk in the morning. They see what's dropped and they see what's similar to, and they just hit the button and they make those trades. So it's just kind of this rules-based trading. That's just, it must be a lot of transactions going on within these accounts over the year,

Starting point is 00:12:15 right? That's correct. Yeah, you don't want to get paper statements for these kind of accounts, I'm sure. So interesting. So now at Invesco, you guys have taken it a little bit further in a sense that I talked about just sort of your plain vanilla strategy, and you can track any sort of index that's out there, Russell 2000 or internationally, depending on what your investment goal is. S&P 500 obviously is a popular one. But talk to me about this idea of enhancing the strategy with maybe, say,

Starting point is 00:12:46 some leverage. You can do some shorting and other things that sort of makes, kind of elongates the runway before you run out of gains. How do you guys approach that? Yeah, happy to answer that, Dave. And one thing we discussed was the challenge that we face with traditional direct indexing are those periods of times in upward trending bull markets. It's really tough to find losses to harvest in your portfolio. is a direct indexing strategy where we use modest amounts of leverage and shorting to still replicate the index, but the shorts allow us to harvest losses as the market trends higher. And that way, we never run out of losses to harvest in the portfolio. Interesting. You still keep that tracking error low, but sort of have this extra lever to pull for harvesting losses, right? So even to educate our audience a little bit,

Starting point is 00:13:50 when you short a stock, you sell it short, but if the stock rises, you actually lose on that trade, right? So you're benefiting even though the market's going up. Hopefully, we're obviously getting gains somewhere else to offset those losses. Net-net, we're still tracking the index, but kind of enhancing that loss harvesting, right? Exactly. And I would add, too, the losses that we harvest are generally short-term losses in nature, which are the most valuable losses. Those are the ones that are taxed at the highest tax rate. So that's another way that we look at these losses that we harvest is how valuable the losses are to the end client. Yeah, and it's not necessarily a big deal.

Starting point is 00:14:33 But if your losses exceed your gains in any given year, you can offset up to $3,000 in income. So from your wage income. So there are some other offsets that can be enjoyed by the investor, right? So let's talk about some scenarios that, you know, what's the typical client? I could imagine somebody maybe that you talked about Apple. They got lucky and 10 years ago, you know, bought a couple hundred shares of Apple and just have sat on that. And now it's a huge part of their portfolio, maybe a little too big.

Starting point is 00:15:05 But they don't really want to sell it because it's going to be a big tax hit, right? How does that scenario work for a potential direct index investor? It's a great example and one we run into all the time. And it's not just Apple, right? You look at the concentration that's been in the market. Also, clients we often see come to us

Starting point is 00:15:25 with corporate stock that they're granted. And it has low basis and it's a good problem to have. It's one problem that we can use a direct indexing approach for. So you can fund these accounts with cash and securities and our goal is to transition out of the securities over time and like I said earlier it's all about balance it's the balance of what is our tax liability what's our tax budget in selling the position and the speed at which we're

Starting point is 00:16:03 going to transition over to the direct indexing that strategy that we're going to follow so we can do that with our long only direct indexing strategy let's say we're tracking the S&P 500 or the Nasdaq 100 we're looking to get ultimately over to that index over time the enhanced strategy that we talked about using the leverage and shorting, we can actually sell out of positions a little bit quicker. In fact, in some cases, we don't have to sell the positions for quite a while because we borrow against them and we use that for the leverage and we use the borrowing to diversify the portfolio. Got it. Okay. So if

Starting point is 00:16:47 somebody's got a big tax problem, you know, overweight in a portfolio, they contribute those securities to a direct indexing account and, you know, slowly chip away at that position as you harvest losses, ultimately to get them more diversified but you're still invested in you know ultimately the S&P or whatever index you you select right that's correct and it's it's one way that we can provide a client with a concentrated low basis stock position with diversification yeah and without the tax bill got it okay that's interesting the other thing that is I think is from a planning perspective

Starting point is 00:17:25 is if you have somebody that knows they're going to have a gain in the future, let's say they're going to sell a business or maybe their house is appreciated a lot over many years around here. We've got folks with beyond that $500,000 tax shelter. So they know they're going to sell their house at some point and they're probably going to have a capital gain. So can I do this and bank losses in advance, you know, of a future event? This is one of the great ways that financial advisors come into play as planners for their clients and looking around corners and what are those issues that are coming down the pike for them. And that's where one of these strategies might come into play where

Starting point is 00:18:11 you never know what's around the corner. Sometimes you do. But if you're able to harvest those losses and bank those losses, it can help mitigate that tax bill that could be coming several years down the road. Jeff, that was great. Really interesting. I think this strategy is, obviously, it sounds very complicated, but at the end of the day, it's really harvesting losses to offset potential gains, right? So as we've talked about before, it's not just what you make, it's what you keep, right? Well said, Dave. It's about getting the market returns, but doing so with the tax benefit alongside of it and doing so at an attractive price point, too. It's one we didn't talk about, but these are often fairly attractively priced strategies as well.

Starting point is 00:18:55 Got it. Interesting. Yeah, the technology these days really makes it efficient to be able to deliver this, as you said, across thousands of accounts really seamlessly. So I think just the way the markets have evolved in electronic trading, commission-free trading, all those things that really weren't around that long ago have enabled these strategies to become cost-effective. And that's really important because, again, cost matters and taxes matter, but you really want to be able to get the returns of the index that you're trying to replicate without too much of a drag from a fee perspective. So that's really important, and we do keep an eye on that. So thank you so much for joining me today. That was a really interesting conversation.

Starting point is 00:19:40 If you have any questions, please give us a call or go to assetstrategy.com. Thanks for watching.

Assets and Taxes - How Direct Indexing Can LOWER Your Tax Bill! | Episode #4

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