Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Direct Indexing for Tax Loss Harvesting
Transcript
- Lucas: So let's say you have five million dollars you want to track the S&P 500. The obvious move: buy an ETF like IVV or VOO, pay three basis points, done. But a growing number of ultra-wealthy families are bypassing the ETF entirely and buying the underlying stocks themselves. Luna: This is direct indexing, right? I've seen the term thrown around, but it always sounded like more work for basically the same result. Lucas: Same index exposure, but the key difference is that when you own each stock individually, you can tax-loss harvest at the single-stock level. If Apple drops ten thousand dollars, you sell Apple, book the loss, and immediately buy something highly correlated — Microsoft, say — to stay invested. You've just captured a ten thousand dollar tax loss without changing your overall market exposure. Luna: And with an ETF, you can't do that. The fund handles its own internal harvesting, but you as the shareholder don't get to pick which losses you realize. Lucas: Exactly. The ETF passes through net capital gains to you, but the timing is out of your control. With direct indexing, you control every trade. For a family in the top federal bracket — twenty-three point eight percent on long-term gains plus the three point eight percent net investment income tax — a ten thousand dollar loss saves you about two thousand seven hundred sixty dollars in taxes that year. Luna: That adds up. But the fees are higher, right? Direct indexing platforms charge what, twenty-five to fifty basis points? Lucas: Roughly twenty-five to fifty basis points, yes, versus three basis points for an ETF. So the question is: at what portfolio size does the tax alpha outweigh the fee drag? Most advisors I talk to say the breakeven is around one million dollars. Below that, the tax savings don't cover the extra cost. Above it, you start pulling ahead. Luna: And it gets better over time, because tax-loss harvesting is a compounding game. You harvest losses in down years, carry them forward, and use them to offset future gains. Lucas: Right. There's research from Parametric — one of the big direct-indexing firms — showing that after-tax alpha typically runs one to two percent annually versus a comparable ETF. Over ten years, that's a significant chunk of wealth preserved. Luna: So who are the main players? I know Parametric, but there's also Aperio, and more recently, Schwab and Fidelity have rolled out their own versions. Lucas: Parametric and Aperio are the legacy firms — they've been doing this for high-net-worth clients for decades. What's changed is that technology has driven costs down, and fractional shares have made it possible to replicate the S&P 500 with as little as a hundred thousand dollars, though the tax benefits really kick in at higher levels. Schwab's direct indexing product, for example, has no minimum and charges twenty-eight basis points. Luna: But at that size, isn't the benefit marginal? If you have a hundred thousand dollars, a one percent after-tax alpha is only a thousand bucks a year. Lucas: It's marginal, but it's not nothing. And if the investor is younger and in a high tax bracket now, those losses can carry forward indefinitely. But the real sweet spot is the multi million dollar portfolio where the fees are a rounding error and the tax savings are material. Luna: One concern I've heard: tracking error. If you're selling Apple and buying Microsoft to harvest a loss, you're not perfectly tracking the index anymore, at least for a few weeks until you can buy Apple back. Lucas: That's the wash-sale rule. You can't buy back Apple within thirty days, so you need a replacement stock that behaves similarly. The platforms use optimization models to minimize tracking error — they hold thousands of stocks, not just the five hundred, and they'll overweight some names to keep the factor exposures close. In practice, the tracking error is usually under twenty basis points annualized, which is small relative to the tax alpha. Luna: So it's essentially a tax-management wrapper around an index strategy. For families that are already working with a wealth manager, it's a fairly seamless add-on. Lucas: Exactly. And it works best in volatile markets, because volatility creates more loss-harvesting opportunities. If the market goes straight up, you don't get many chances to harvest. But in a choppy environment — which we've had a lot of over the past year — it can be very effective. Luna: Let's talk about a concrete example. Say a family has a five-million-dollar S&P 500 direct index at the start of the year. Over the year, the index returns eight percent, but individual stocks are all over the place. Some are up, some are down. What kind of tax loss could they expect to harvest? Lucas: Parametric publishes some data on this. In a typical year, you might harvest losses on about three to five percent of the portfolio value. So on five million, that's a hundred fifty to two hundred fifty thousand dollars in realized losses. At a twenty-three-point-eight percent federal rate, that's roughly thirty-six to sixty thousand dollars in tax savings for that year. Luna: And those losses can be used to offset capital gains from other parts of the portfolio — maybe a private equity distribution or a real estate sale. Lucas: Or carried forward indefinitely. There's no expiration on capital loss carryforwards. So if you have a year with no gains, you just keep the losses on the books for future years. It's effectively a deferred tax asset. Luna: One nuance: the IRS allows you to deduct up to three thousand dollars of net capital losses against ordinary income each year. So even if you don't have capital gains, you can still get a small ordinary income benefit. Lucas: Right, but for high-net-worth families, three thousand dollars is trivial. The real value is in offsetting large realized gains from other investments. That's where the tax savings become significant. Luna: So direct indexing is essentially a tax-loss harvesting engine built into a passive portfolio. It's not sexy, but it's very effective. Lucas: It's not sexy at all, which is probably why it took so long to catch on outside of ultra-wealthy circles. But as the fees have come down and the technology has improved, it's becoming a standard recommendation for any taxable account above one million dollars. Luna: And it's not just for the S&P 500. You can direct index international indexes, factor-based strategies, even ESG screens. Lucas: That's one of the big selling points — customization. A family might want to exclude certain stocks for ethical reasons, or overweight sectors they believe in. With a direct index, you can do that without sacrificing the core index exposure. Luna: And you're not locked into the index provider's methodology. If you want a slightly different weighting scheme, you can adjust. Lucas: Exactly. It's a bespoke index. And the tax-loss harvesting is layered on top of that customization. So you're getting both personalization and tax efficiency. Luna: For listeners who are intrigued but don't have a million dollars yet, is there a way to get started with less? Lucas: A few platforms have lowered minimums. Schwab's product has no minimum, but the per-account fee of twenty-eight basis points is relatively high for small accounts. Fidelity's direct indexing product has a minimum of five thousand dollars, but again, the tax benefit at that level is modest. I'd say it's worth considering once you have at least a quarter million dollars in a single taxable account, and it really becomes compelling above five hundred thousand. Luna: And you'd want to be in a high tax bracket, and ideally in a state with high income taxes, because state-level deductions add another layer of savings. Lucas: Absolutely. In California, the top state rate is thirteen point three percent, so the combined federal plus state benefit on a long-term capital gain is over thirty-seven percent. That makes the tax alpha even larger. Luna: One last thought: direct indexing requires more trading activity than an ETF, which means more short-term capital gains if you're not careful. How do platforms manage that? Lucas: They're very mindful of it. Most platforms have algorithms that prioritize holding stocks for more than a year to ensure gains are long-term. And they avoid wash sales by using a list of permissible replacement securities. The net effect is that the tax alpha from harvesting losses far outweighs any incidental short-term gains from rebalancing. Luna: So it's a well-engineered product. And for families who are already paying a wealth manager, the incremental cost is often negligible. Lucas: If our money conversations have helped you think about a decision differently, honestly, if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. It's a small gesture that keeps these conversations ad-free and independent. Luna: Yeah, we don't have ads, so listener support is what makes it work. And it's appreciated more than you'd think. Lucas: Back to the topic — one thing I want to emphasize: direct indexing is not a set-it-and-forget-it strategy. You need to monitor the tax-loss harvesting activity, especially at year-end, to avoid wash sales across multiple accounts. If you have a direct index in your taxable account and you also own Apple in your IRA, selling Apple for a loss in the taxable account and buying it in the IRA within thirty days would create a wash sale. Luna: That's a common pitfall. Families with multiple accounts need to coordinate. The platforms often have tools to flag cross-account wash sales, but it's something the advisor needs to watch. Lucas: Right. And if you have a direct index and separately managed accounts for other strategies, the tax-loss harvesting can interact in complex ways. It's definitely a strategy that benefits from professional oversight. Luna: But for the right family, it's a powerful tool. It's essentially turning market volatility into a tax advantage. Lucas: And that's the core insight: volatility isn't just risk — it's also opportunity. Direct indexing lets you monetize that opportunity in a tax-efficient way. For high-net-worth families, it's become a standard part of the toolkit. Luna: I'd love to see how this evolves as more platforms enter the space and fees continue to fall. At some point, it might make sense for almost any taxable investor. Lucas: We're not there yet, but we're moving in that direction. For now, it's a strategy that's worth a conversation with your advisor if you have a significant taxable portfolio. Thanks for listening.