Direct indexing is an investment approach that seeks to track the performance of a stock index by investing in individual stocks comprising the index. An investor holding a direct indexing portfolio can obtain tax benefits by harvesting losses on individual stock positions. We show that investors with allocations to hedge funds and derivatives are the most likely category of investors to have systematic short-term capital gains in their portfolios and, therefore, benefit the most from losses harvested by direct-indexing strategies. After the initial few years since inception, tax benefits offered by a direct-indexing strategy are only available to those investors who can take advantage of the difference in tax rates applicable to short-term and long-term capital gains, that is, investors with short-term capital gains from other investments. In connection with this, we show how tax benefits are affected by equalizing the tax rate applicable to long-term and short-term capital gains, like under the proposed Biden Tax Plan. Investors can increase tax benefits of a direct-indexing strategy by contributing capital to the strategy and increase them even further by combining the strategy with a charitable giving program. We use a character-deferral decomposition to explain why tax benefits of direct-indexing strategies decay with time since inception and why these tax benefits are increased by capital contributions and charitable giving.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.