How Direct Indexing Can Benefit From Volatility

The continued market volatility is making many investors justifiably nervous, especially high-net-worth investors seeing their portfolios drop in value while still expecting high capital gains. But there’s one way that high-net-worth investors can take advantage of market choppiness: using direct indexing technology for tax-loss harvesting opportunities.

Tax loss harvesting involves selling an investment at a loss, then reinvesting the proceeds of that sale into another asset. This strategy can turn capital losses into a gain and help investors retain their portfolios’ values.

While investors can’t sell individual failing stocks for tax-loss harvesting purposes within a mutual fund or ETF, they can sell securities at a loss to offset capital gains through direct indexing. A direct indexing portfolio is a separately managed account based on a benchmark whereby the investor owns the individual stocks that represent the chosen index. But as opposed to traditional SMA, direct indexing offers scalable, automatic tax-loss harvesting.

Direct indexing services such as Vanguard Personalized Indexing include automatic processing features that scan for tax-loss harvesting and rebalancing opportunities daily. For investors with large recurring capital gains, these automated features can increase after-tax alpha from 20 basis points to more than 100 bps.

See more: “Direct Indexing or ETFs: What’s the Right Option?”

“Volatile markets provide an abundance of opportunities for tax-loss harvesting, since periods of loss in the stock market are often quickly followed by periods of rebounds,” according to Vanguard. “In addition, when markets are in high volatility mode, volatility is likely to persist in the near term, with the best and worst days tending to cluster around each other.”

Vanguard Personalized Indexing can help capitalize on volatile markets without violating the wash-sale rule, which states that if an investment is sold at a loss, then repurchased within 30 days, the initial loss can’t be claimed for tax purposes. Vanguard Personalized Indexing’s daily scans flag accounts for tax-loss harvesting opportunities in a market downturn.

Its portfolio managers review each flagged opportunity to make sure it will in fact result in positive outcomes. If approved, the account is traded to realize losses, and those trades are added to a restriction file.

If the market is still down a few days later, Vanguard flags the account again for tax alpha opportunities. When losses are harvested this second time around, Vanguard’s direct indexing software avoids the securities in the restriction file, which stops investors from being locked out of the market for 30 days because of the wash-sale rule and allows them to take advantage of tax-loss harvesting opportunities that happen in rapid succession of one another.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.