Canada could soon see a new structure for tax-advantaged investing

Direct indexing allows investors to directly purchase all or some of the securities in a given index through a separately managed account. Owning the securities directly instead of through an ETF creates two main opportunities: tax-loss harvesting and index customization.

Tax-loss harvesting

Jeff Brown, director and institutional portfolio manager at Parametric, said his firm’s tax-managed accounts have two goals: to track, with acceptable tracking error, a given index; and to outperform after tax.

Brown explained that direct indexing usually involves owning a certain percentage of the index, rather than all the underlying securities. That means if one owned security has a tax loss, the client can realize that loss and then “look to the bench” to substitute an un-owned security into the customized index, Brown said.

“That capital loss is yours to use somewhere else, but at the macro level, that [direct indexed] portfolio still looks like the index,” Brown said.

The options for tax-loss harvesting are even greater when it comes to broad indexes — in a given year, there are likely to be some losses to harvest.

“A core index like the Russell 1000, with its relatively large number of constituents, is useful for advisors who want to implement a direct indexing strategy as there are more constituents to work with,” said Hillary Keitel, head of U.S. wealth at FTSE Russell in New York.

The tax benefits of direct indexing can also apply to charitable giving: clients can work with their providers to donate individual securities with high unrealized gains and substitute their place in the direct index with an un-owned security.

In Canada, direct indexing’s tax-loss harvesting benefits are somewhat muted compared to the U.S., where each security’s individual cost base is honoured under what’s known as “tax lot accounting.” Under Canadian tax rules, multiple purchases of the same security result in an adjusted cost base across all units of the same security.

In a presentation at Inside ETFs, Langstraat shared that tax-managed accounts make up 77% of Parametric’s US$175 billion in assets under management (AUM) and 96% of the firm’s accounts.

Customization

Direct indexing can help clients who have strong environmental, social and governance (ESG) views, since they can specify which securities they want removed from a broad index.

About 15% of Parametric’s AUM and 10% of its accounts are customized according to ESG and responsible investing (RI) strategies, Langstraat said in his presentation.

Customization can also help clients who are heavily concentrated in certain securities or sectors due to their employment history (e.g., thanks to share-based compensation). Direct indexing would allow the client to invest in broad indexes while removing the securities in which they’re concentrated.

Brown stressed that end clients drive investment and customization choices, not his firm.

“We are index-agnostic,” he said. “You [the client] work with your advisor, they come up with an asset allocation and benchmark selection, and then you tell us what you want and we build it.”

The right kind of client

Brown and Langstraat acknowledged that direct indexing is not for every client.

Due to its customized nature, direct indexing is more expensive than conventional investing. That cost “is commonly more than compensated by the value of customization, but it’s real,” Langstraat said during his presentation.

He added that the complexity of direct indexing, compared to the simplicity of a mutual fund or ETF, can be a turn-off to some clients.

An ideal direct indexing client would want to invest in a broad basket of securities, be subject to high marginal tax rates, have a long-term investment horizon and have specific views on investments. That client is also high-net-worth: Parametric’s per-account minimum is US$250,000.

For suitable clients, however, Langstraat argued that direct indexing can strengthen the advisor-client relationship because it allows the advisor to offer “a bespoke portfolio they can’t get from somewhere else. [Direct indexing] allows [advisors] to engage in conversations about estate planning, philanthropy, ESG and RI with a real portfolio on the table.”

Other firms that offer direct indexing in the U.S. include CLS Investments in Omaha and Optimal Asset Management Inc. in Los Altos, Ca.