Direct indexing solutions for tax-efficient diversification

Some investors have a large portion of their wealth tied to just a handful of stocks, or perhaps even a single stock. But this can be a mixed blessing. Once you’ve made your fortune, the next big challenge is keeping it. 

Having too much invested in a small number of holdings exposes investors to concentration risk – the risk that one stock could suddenly wipe out their wealth. Many people don’t believe it could happen to them, but we’ve all seen it happen with Enron, Lehman, and other companies that were rock solid at one point. 

One thing that prevents people from diversifying when they know that they should is the tax consequences. If they sell their existing shares to diversify, they may be faced with a large tax on the capital gain. What we see is that many people would rather take their chances on a big market loss in the future than be forced to pay taxes to Uncle Sam today. But this can be a very risky strategy. 

Natixis Investment Managers Solutions can address this challenge, using a tax-managed, direct indexing strategy in a separately managed account. Instead of selling all of the shares at once, investors can sell smaller portions over time to spread out the tax burden over multiple years. 

Selling batches of shares may also create opportunities to harvest losses from the newer positions to offset the taxable gains on the older shares. We often use a capital gains budget to unwind the concentrated position, based on the investor’s priorities. Investors with a higher capital gains budget may be able to diversify their holdings more quickly, and have lower tracking error to the index. Conversely, for investors less willing to pay capital gains up front, the process may take longer and the tracking error may be higher initially.  

But in either case, the result can be a smaller total tax bill than if the stock were sold outright. Let’s use a large position in a tech stock as an example. The goal may not be to eliminate the large position entirely, but to build an index-like portfolio around it over several years and to minimize gains in any single year. Each time the shares are sold, the proceeds help fund other non-tech index sectors of the portfolio.

Unwinding large positions can be a bit of a balancing act, but this approach provides two key benefits: reducing the tax burden of selling appreciated shares and building greater diversification into the overall portfolio.