One way to reduce your tax drag is to use more tax-efficient vehicles. By vehicle, we mean the format or type of product that you are using in your portfolio. For example, you can invest in the S&P 500 through several types of investment vehicles. For the purpose of this article, we’ll limit our discussion to three of them: mutual funds, exchange-traded funds (ETFs) and Direct Indexing. All three can offer virtually identical investment exposure but each has a different degree of tax efficiency.
Mutual funds are typically the least tax-efficient of the three, and this is because they are required to pay 95% of realized gains to shareholders in a given year. This is true regardless of whether an investor has held that mutual fund all year or bought it right before that capital gain distribution is paid. In other words, you as the investor could face a tax consequence without having enjoyed much of the return. ETFs, by contrast, are more tax-efficient because their structure leads to much lower capital gain distributions—often none at all. Direct Indexing, in which a professional manager buys and sells individual securities in your brokerage account to match an index like the S&P 500 or a more actively managed investment strategy, is the most tax-efficient vehicle currently available. Not only is direct indexing not subject to the problem of capital gain distributions, but it also creates much more opportunity for the tactic we described above, tax-loss harvesting. Think about it like this: your S&P 500 investment might be positive over a certain time period, even if some of the underlying stocks are negative. If you own the mutual fund or ETF, you won’t be able to harvest any losses in this case. However, in a direct indexing strategy, the investor has the ability to target only those stocks at a loss and further reduce their taxes.
This should not be construed as advice to shun all mutual funds and ETFs in favor of direct indexing. Many diversified strategies are still only available in those vehicles, and if your after-tax return in a mutual fund can be better than what is available via direct indexing, you should stick with the mutual fund. This is particularly true in retirement accounts, in which capital gains are not even subject to tax. That said, investors—especially those in higher tax brackets—should at least be aware of this increasingly available investment vehicle when they are constructing their portfolio.