Tax-Loss Harvesting With Direct Indexing

With half of 2023 in the books, investors could already start thinking of how to minimize their tax burden when 2024 comes around. One way is via tax-loss harvesting, which is an advantage of direct indexing.

This involves selling off assets at a loss in order to offset profits. The assets sold off at a loss can be replaced with similar or identical assets. For example, an exchange traded fund (ETF) sold at a loss could be supplanted by another ETF.

The challenge with ETF tax-loss harvesting is its holdings, which can be vast depending on the strategy of the ETF. Investors can’t focus on specific holdings in a fund to account for a loss with the same precision involved when harvesting for individual stocks.

This is where direct indexing could be of benefit for harvesting. The strategy involves hand-picking stocks for a portfolio in order to mimic an index. In the case of the S&P 500, a direct indexing strategy would involve choosing holdings that mirror the S&P 500.

Given this ability to tailor a portfolio with individual stocks, investors can harness tax-loss harvesting with more accuracy. In order to do the same thing with an ETF, certain underperforming stocks would have to comprise a sizeable portion of an ETF’s holdings in order to negatively affect its performance.

“Direct indexing portfolios make it simple to handle precise tax-loss harvesting, since it’s easy to sell underperforming individual stocks,” Forbes Advisor explained. “Take the cash from each tax-loss sale and buy shares in similar companies to balance your portfolio’s allocations. Meanwhile, you’ve generated a capital loss that you can use to reduce your overall tax liability.”

An Automated Way to Tax-Loss Harvest

Now comes another challenge: looking for individual stock opportunities in the market to take advantage of tax-loss harvesting. This is where a service platform like Vanguard Personalized Indexing can identify opportunities for tax-loss harvesting in an automated fashion.

The platform uses algorithms that can identify opportunities at various parameters. These customization options afford the investor or advisor a broad array of advantages.

“How frequently the direct indexing technology scans a portfolio for tax-loss harvesting opportunities—quarterly, monthly, or even daily (as with Vanguard Personalized Indexing)—is key to maximizing investors’ tax alpha,” Vanguard noted on its product website. “Direct indexing with daily tax-loss harvesting has boosted certain investors’ after-tax returns by 1%–2% or more.”

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