America's Best Direct Indexing Buyers Guide 2024 - 10

2024 DIRECT INDEXING BUYERS GUIDE
Direct Solutions to Common
Client Problems
1. Tax Alpha Is Real
Taxes can be one of the largest
hidden costs your clients pay on their
investment portfolios, and neither they
nor you, as their advisor, may fully
grasp the extent of this impact.
While many are aware of taxes on
dividends, interest and capital gains,
there are often hidden tax costs
lurking beneath the surface. These
hidden taxes arise from activities
like rebalancing, changes in asset
allocation, manager adjustments or
switching funds within a portfolio.
According to Morningstar, active U.S.
equity funds lost an average of 1.72%
in returns annually due to taxes over
the five years ending December 2023.
For a mutual fund with a pre-tax return
of 10%, the after-tax return drops to
8.28%.
This tax drag can significantly
outweigh the fees most advisors
charge, and it represents money lost
that could otherwise be invested and
compounded. These hidden costs are
real and affect your clients' wealth.
The key is not just what your clients
make on their investments, but what
they keep. Proper tax management
can save your investors significant
amounts. Taxes can erode returns,
but advisors who focus on tax-efficient
investing stand out and provide clear
value.
For advisors, it's essential to account
for these impacts when making
portfolio adjustments. Quantifying the
tax costs alongside the risk and return
benefits is crucial. Tools like the 1099DIV
tax form can help analyze a client's
tax health, revealing if their tax costs
are higher than necessary.
Even a 1% tax drag each year can
significantly reduce a client's overall
wealth, especially when compounded
over time. The difference between a
well-managed, tax-efficient portfolio
and one with high tax costs could
mean the difference between a secure
retirement and a more uncertain one.
Advisors who prioritize tax-smart
strategies not only help clients but
also differentiate their practice. If you
can answer " yes " to questions about
knowing your clients' tax rates, offering
tailored solutions for taxable and nontaxable
assets, explaining the benefits
of tax management, partnering with
CPAs, and reviewing tax returns, then
you're already on the right path.
Ultimately, communicating the value
you bring as an advisor is essential.
The strategies discussed here and
throughout the series are only valuable
if clients recognize and appreciate
them. Elevating your value starts with
clear communication, and focusing on
tax efficiency may be one of the best
ways to demonstrate your impact.
Tax-Loss Harvesting: Employing a
direct indexing strategy that holds
the underlying securities enables
you to harvest losses on individual
positions, offsetting capital gains taxes
elsewhere. This reduction in capital
gains taxes lowers the tax burden for
investors, enhancing your reputation in
their financial journey.
Deferral of Capital Gains: Direct
indexing facilitates the postponement
of capital gains, allowing them to
accumulate without taxation until the
investor decides to realize the profits.
This approach prevents the sale of topperforming
securities in the absence of
losses to harvest and/or when delaying
capital gains aligns with a lower tax
bracket. While not a novel technique,
direct indexing has now made it
convenient for mass affluent investors.
2. Managing Around Concentrated
Positions
No success goes unpunished forever.
A great stock can soar to the point
where it becomes a substantial portion
of a client's net worth, especially
if employment benefits provide an
incentive to buy more shares at a
relatively early stage or the shares were
inherited from a relative.
However, these concentrated positions
carry their own risks that the process
that created the wealth in the first
place will run in reverse. Diversification
Historical Tax Alpha (in BPs)
Adhesion Clients Enrolled in Active Tax Management
180
160
140
120
100
80
60
40
20
5-Year Average Tax Alpha
With Direct Index = 93.69
Without Direct Index = 69.77
156.80
133.22
116.72
100.96
46.90
2018
104.44
62.05
31.92 25.67
2019
With Direct Indexes
Courtesy of Adhesion Wealth, 2024
38.61
2020
2021
Active Tax Management Only
2022
10
America's Best Direct Indexing Buyers Guide 2024

Table of Contents for the Digital Edition of America's Best Direct Indexing Buyers Guide 2024
