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The power of direct indexing · UBS Trending

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  Taxes can quietly erode your investment returns.
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  But there are new tools
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  like direct indexing that are helping investors fight back.
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  So what is direct indexing
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  and how can it improve after tax outcomes?
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  We're going to talk about that
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  and break it all down for you right now.
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  On UBS Trending.
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  Hi everybody and welcome to UBS Trending. I'm Anthony Pastore.
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  Thanks so much for joining us today.
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  I've got Brian Smith from Eaton Vance
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  joining me here in the studio.
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  We've got a lot to get to. So Brian, first of all welcome to you.
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  Good to have you here.
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  Thank you so much for having me. Great.
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  So, you know,
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  obviously,
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  you know, there's a couple of guarantees in life, taxes
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  being one of them.
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  We all have to pay taxes.
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  We all have to deal with taxes every year.
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  Every day.
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  Talk about the sort of the consequences and the,
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  you know, towards investors and why taxes matter so much,
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  especially for those that maybe aren't
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  as involved in their day to day investing
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  and how that plays into the success
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  or the returns in a portfolio.
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  Yeah. You know, I think your opening kind of framed it.
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  Taxes can silently erode returns, and many investors
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  or most investors
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  are holding part of their wealth within taxable portfolios.
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  And so we think about all of the different things that can create
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  what I refer to as tax friction.
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  So that is turnover of any kind.
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  Even things that are prudent.
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  You're doing the right thing within your asset
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  allocation, such as rebalancing moving assets from one asset
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  class to another
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  and making sure that you stay within the right risk parameters.
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  That turnover means that you're selling some of your winners
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  and reallocating to some of your losers.
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  That means that you're creating tax friction.
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  You're realizing gains.
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  And so as we think about what that can do to a client
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  portfolio over long periods of time, as this
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  erosion takes place,
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  even though it seems incremental in the moment, it adds up.
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  Sure.
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  Any dollar that you take off the table
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  and you ship it off to the IRS, that's a dollar
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  that you don't have as a productive part of your portfolio.
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  So if you can alleviate that even incrementally,
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  you've created this compounding engine
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  where you can put a lot more wealth
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  in a client's pocket over time. Right.
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  And so even just looking at this slide here,
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  this would be if you could invest
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  in the S&P 500 frictionless in a world with no taxes.
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  And if you see like the average return of the S&P 500
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  over a 20 year
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  period, $1 million would grow to about 3.8 million.
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  If you then bring this portfolio into the real world with taxes,
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  if you were to put a 1% tax drag
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  or even a 2% tax drag on that same investment mandate,
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  the amount that you have over 20 years is substantially stunted,
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  right?
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  I mean, over decades, it could cost hundreds of thousands,
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  if not millions,
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  depending on how much your investment is towards
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  your bottom line.
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  So, right.
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  So obviously we're here to kind of talk to our viewers about ways
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  to maybe try and avoid some of those tax consequences.
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  And we talk about direct indexing.
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  So let's get into what it is and how it applies to this
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  tax conversation.
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  Direct indexing itself.
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  Yeah.
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  So direct indexing is is basically a passive form of investing.
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  So many folks are incorporating
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  passive management into their asset allocation
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  in one way or another.
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  That might be large cap or something like the S&P 500,
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  but it really can go anywhere.
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  You could passively orient towards
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  large, mid, small developed international emerging markets.
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  You pick a benchmark.
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  And there's been different ways
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  that folks have gone about incorporating
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  that into their portfolios.
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  Historically
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  indexed mutual funds have been around for a really long time.
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  And then we saw this
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  incredible flare proliferation into ETF utilization,
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  direct indexing.
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  Think of it as basically the next frontier in indexing,
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  rather than going with one of those co-mingled structures
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  like a mutual fund
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  or an ETF where you're investing alongside other folks.
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  What direct indexing is, is a separately managed account.
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  You own the underlying holdings directly.
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  So we're building an index
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  using the component parts by the individual securities.
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  Now that opens up the door to to two things.
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  One is systematic tax management.
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  The market regardless of which market you're looking at,
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  there is systemic volatility that gets experienced.
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  Meaning that individual securities
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  are not necessarily having the same experience
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  as the market as a whole.
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  Someone's having a bad day,
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  whether that's a sector, an industry or an individual security.
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  If it falls below its cost
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  basis, you have the ability to actually tax loss harvested.
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  And tax loss harvesting is an incredibly powerful tool
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  that leads to your ability to defer payments to the IRS.
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  So when you have a loss, it actually has economic value to you
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  as an investor.
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  The other thing that direct indexing opens the door to
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  is customization,
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  rather than going and buying something off the shelf.
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  You could ask us to custom construct an exposure.
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  So I want the S&P 500, but don't buy my employer stock,
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  or don't buy fossil fuel, or don't buy companies
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  that are involved in XYZ that you type of, you know, engagements.
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  So it allows for you to really tailor exposure
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  specifically to the investor, right?
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  My producer Kyle loves a metaphor.
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  And so I told him that I was going to say to you today
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  because I thought about this
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  and I've thought about,
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  well, obviously, SMEs are a huge part of our business here at UBS
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  and with our partners like you all,
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  but it's like going to the grocery store.
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  You can either buy the prepared meal in the freezer case
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  or the fresh fruit case as it is,
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  or you can buy all the individual ingredients to make that meal.
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  But say you don't like cilantro,
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  you can leave that out, but you like a little spice.
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  You can add a little extra Tabasco sauce and customize it
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  to the way that you want that to end up being on your plate.
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  So if that makes sense,
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  and that's sort of a way to kind of put it in
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  layman's terms for those who are like, oh, okay,
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  I see
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  totally customizable working with your financial advisor
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  to make sure it has what you want in there, and you can buy
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  and sell out to avoid some of those tax consequences.
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  I think it's the perfect analogy.
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  I might even add in with a personal chef,
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  because you don't have to do the cooking. Good, good, good.
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  I like that you know, if you buy the prepared meal
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  because of the ease of use, this doesn't add any complexity.
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  You're not necessarily sacrificing anything.
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  Your expectation for returns is almost identical.
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  You're just getting the tailored exposure where you selected
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  the ingredients.
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  I do love that. I know, great, I'm glad, I'm glad.
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  And I think Kyle will like it as well.
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  So let's talk about the after tax outcomes for those investors
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  who are utilizing direct indexing SMAs in their portfolios.
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  Yeah.
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  So let's maybe
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  dig into that that concept of tax
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  loss harvesting a little bit more.
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  Because what I found is that the word loss can sometimes,
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  cause a visceral reaction for folks.
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  They hear, like the word loss. Did I lose money?
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  So the markets are having this noise all the time.
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  It doesn't matter what benchmark we're looking at.
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  It doesn't matter over what time period you're looking at.
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  There are some securities within it, like using the S&P 500
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  as an example.
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  Some securities are going to cross below their cost basis
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  and be held to the loss.
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  What parametric can do or what direct indexing can do is we can
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  look at that security
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  when it crosses below its cost basis, we can sell out of it
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  that means that a loss carries over to your 1099
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  at the end of the year.
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  With the proceeds from that sale,
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  we identify a risk equivalent replacement.
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  So we find something that has a light kind of exposure
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  that contributes to the risk
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  characteristics of the benchmark in the same way,
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  so that your expectations for performance do not change,
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  you still have expectations
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  of mimicking that benchmark on a go forward basis.
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  But now that I have a loss that has carried over to my 1099,
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  I can offset gains elsewhere.
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  So in that example I mentioned at the beginning,
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  if you're rebalancing your portfolio and you need to trim down
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  small cap
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  because you need to allocate more to developed international.
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  So, you know, the portfolio is adjusting.
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  If within your direct indexing account, your tax loss harvesting,
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  you can basically match your gains and losses,
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  net them when you go to file and you should owe less to the IRS.
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  You kept more money at work
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  by simply just incorporating opportunistic tax management, right?
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  I remember during the great financial crisis,
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  I was working at a firm whose stock price
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  went from 60 to about a dollar, and I was stuck in stock options.
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  I couldn't do anything with them.
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  But I remember freaking out
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  and my advisor said to me at the time,
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  don't worry, we're going to take all those losses.
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  We're going to leave them in your portfolio
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  and we're going to offset any gains you might get in the future,
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  which I was lucky.
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  You're lucky to get any gains at all sometimes in the markets.
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  But I remember freaking out on the word loss
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  because that was a really good example that you gave.
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  But losses
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  can actually help you out
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  when it comes to your tax consequences if you're getting gains
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  later on in your portfolio.
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  So I'm glad. I'm glad you walked us through that, Brian.
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  Last thing is, let's talk about the type of investor that direct
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  indexing is a good fit for, because maybe obviously
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  there's always risk.
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  It doesn't mean you're always going to make money.
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  It doesn't mean you're always going to offset those taxes.
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  So there was like
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  obviously risks in in
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  investing in any product or kind of a vehicle.
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  Talk about those that it's good for.
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  Yeah, I'd say,
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  you know,
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  most folks can probably benefit from incorporating direct
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  indexing somewhere into their, their total, portfolio,
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  you know, anyone who is paying taxes.
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  So it's not going to be a great fit
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  for a retirement account, but within a taxable portfolio,
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  there's a bunch of different ways
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  that we're seeing folks adopt direct indexing.
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  One is I would almost refer to it as a core satellite approach
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  plug direct indexing in for something like large cap.
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  So I'm sure no one would be surprised to hear that S&P 500 is
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  is the number one benchmark. Folks are asking REITs to replicate.
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  So you have
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  that is the centerpiece
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  and then satellite around it with active management
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  or other investments like alternative investments
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  that are just less tax sensitive.
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  They're higher conviction higher turnover.
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  And that's okay. That doesn't make them bad.
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  They're a great complement for direct indexing.
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  So then other folks might say, well,
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  I've got a large cap manager that I like.
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  So this would almost be the inverse satellite direct indexing.
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  Choose it for something like small cap
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  mid cap developed international
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  a different asset class within your broader asset allocation.
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  Another application that we're seeing very frequently
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  is for money in motion.
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  If you have a collection of securities today,
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  whether that is an existing separately managed account
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  manager, maybe a self-directed portfolio,
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  and you would like to migrate that exposure and say,
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  I don't want that anymore.
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  I'd rather just index this exposure.
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  Parametric or direct indexing providers can transition
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  what you own, really tax efficiently, and migrate you
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  to look more like the benchmark over time.
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  So rather than ripping the Band-Aid off
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  and taking a whole bunch of turnover in your account,
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  we can be really tax sensitive during your onboarding process.
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  Again, in that theme of tax deferral,
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  if you can kick the can down the road and be really sensitive
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  about turnover, it keeps more money in your pocket.
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  And then maybe the last one that I'll mention is,
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  around customization.
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  We see a lot of folks that come to us and say, I work
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  for a publicly traded company
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  one maybe I want to start unwinding that.
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  So I'm looking for tax coupons as I'm starting my sell strategy,
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  or I'd like to build a completion portfolio and contemplate
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  the risk of my employer stock in this direct indexing account.
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  Or maybe it's something more values based, some sort of passion
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  that you'd like to incorporate and see reflected within your,
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  your portfolio.
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  Excellent, Brian.
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  Thank you.
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  Yeah, it's
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  great to have these conversations because I think a lot
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  maybe there are some folks out there
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  who don't know that there are opportunities or,
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  you know, options for them
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  to, you know, think about a different way to invest
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  in their portfolio.
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  Obviously, working
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  with, like you said,
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  that Chef that's going to come to the House
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  to put those ingredients together,
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  aka their financial advisor, to help walk through,
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  what's appropriate for their portfolio.
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  So Brian, thanks for walking us through. Good to see you.
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  Thank you for having me. Thank you very much.
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  Brian Smith from Eaton Vance. And thank you all for joining us.
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  There's a lot more information on everything
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  coming from UBS and our great partners
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  like Eaton Vance at our insights website at ubs.com/views.
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  Lots of content there for you.
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  And as always, as we mentioned,
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  please make sure you're continuing this conversation
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  with your financial advisor.
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  Until next time I'm Anthony Pastore.
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  Have a great rest of your day everyone, and remember
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  to keep your eyes on what's trending. We'll see you soon. Thanks.