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A Better Way To Approach Index Investing

Many studies have revealed that the majority of so-called ‘active’ money managers, who try and beat the market, rarely do so. When their performance is compared against their ‘benchmark,’ like the S&P 500, they come up short.

If you like the concept of index investing – capturing market returns with low fees – but you are doing this with index funds or ETFs, you may be losing many significant tax benefits. If you’re a wealthy investor who likes indexing,  there is better approach! Read on to learn more.

Investors who have used an index approach during the recent bull market have been well rewarded for their efforts: (1) They captured the performance of a market that has more than doubled in the past 8 years, and (2) They kept their costs low, because index funds and ETFs generally have lower fees than active money managers.

However, for wealthy investors, there’s one very important limitation to index funds and ETFs – tax efficiency. When you buy an index fund or ETF, you own all of the stocks in the index and your results are the average result of all the stocks within the index. You have no control over what happens to the individual stocks in the index, specifically the tax consequences.

In any given year, even in the middle of a long bull market, some of the stocks in the index or ETF will be down. However, if you own an index fund or ETF, there isn’t any way to ‘harvest’ the losses and offset them against your gains. But for wealthy investors, these tax losses can work in their favor and be very beneficial.

A better way to approach index investing is to follow a tax-efficient index strategy that’s designed to capture the loses in any particular index. Here’s how this works.  First, instead of investing in index mutual funds or ETFs, you invest in a portfolio of individual stocks that is designed to ‘replicate’ an index. For instance, it’s possible to match the risk/return characteristics on the S&P 500 with about 250 of the stocks in the index. Second, on a regular basis you sell stocks when their prices decline. The sales of the ‘losers’ generate tax losses that can be offset against any gains in the index portfolio or against any other gains the investor might have.

For wealthy investors,  who may face income taxes of 40% to 50% and capital gains taxes of 25% to 30%, the after-tax return is what really matters. The main take-away: if you like index investing but are faced with major tax implications as a wealthy investor – a tax-managed portfolio of individual stocks may produce a better result than an index fund or ETF.

Additionally, like any type of investing strategy, there are some caveats to keep in mind. For instance:

Tax-efficient index portfolios have minimum entry points, so most managers have a minimum of $500k to $1 million for indexing large cap stocks along with the possibility of higher minimums for mid cap, small cap and international stocks.

Indexing works best in the most ‘efficient’ segments of the market, where the majority of managers don’t  beat the index – generally in US stocks and developed international stocks.

Keep an eye out for so-called tax-efficient ‘overlay’ portfolios – this approach utilizes a 2nd portfolio that’s overlaid on top of an existing portfolio that attempts to add some tax-efficiency. It may be better than nothing but it’s often not as good as the direct tax-managed portfolio.