Orion Exec Explains How Custom Indexing Supports Tax-Loss Harvesting And Provides Other Benefits
As the weather turns cool and farmers reap another year’s harvest, we enjoy incorporating symbols of harvest like gourds, hay, corn and pumpkins into Thanksgiving decoration. But there’s a very different harvest afoot in many advisors’ offices across the country – tax-loss harvesting.
Approaching the year-end deadline most clients face for completing the tax year, tax-loss harvesting moves to top of mind for many advisors, and with it, one of the better-known tools to manage the harvesting – custom indexing.
To learn more about the benefits of custom indexing, including tax-loss harvesting, we spoke with Andrew Rosenberger, Head of Custom Indexing at Orion Advisor Solutions, a wealthtech firm serving $3 trillion in assets under administration and $56 billion of wealth management platform assets, and supporting over 5 million technology accounts.
Launched five years ago, the firm’s custom indexing solutions have grown to over $1 billion in assets.
We asked Rosenberger to describe the benefits of custom indexing, both specific to tax-loss harvesting and beyond, as well as common misconceptions about tax-loss harvesting.
WSR: What is custom indexing and how does it relate to tax-loss harvesting? How can advisors and their clients benefit from these tax-loss harvesting capabilities?
Rosenberger: Custom indexing is a technology solution that allows advisors to unwrap traditional market indexes and hold many of the underlying stocks that make up the index. Unlike an ETF or mutual fund, which is off-the-shelf and commingled with other clients’ assets, a custom index portfolio is personalized to every investor. That personalization can come in many forms but is most often used for tax management.
Tax-loss harvesting is the most popular benefit of custom indexing. Whereas an ETF or mutual fund is only one tradable position, because custom index portfolios own many names that comprise the index, each underlying position has the potential to be harvested. The more names held in a portfolio, the more potential for tax-loss harvesting opportunities.
As an example, from 2011 to 2021, the Russell 3000 was negative only one calendar year. However, on average, nearly 38% of all stocks in the index finished negative during the calendar year. Investors holding only the index would see very few opportunities to harvest losses. Investors holding the stocks that constitute the index would have had a similar return to that of the index, plus had several more opportunities to harvest losses along the way.
WSR: What are some misconceptions about tax-loss harvesting?
Rosenberger: There are two common misconceptions about tax-loss harvesting:
First, many believe tax-loss harvesting should occur at year-end. Although harvesting losses at year-end is better than not at all, a yearly approach fails to take advantage of intra-year volatility.
For example, in a year like 2021 when COVID drove down markets in the beginning of year but recovered quickly, investors harvesting losses at the end of the year would have completely missed out on the first quarter drawdown. Our approach at Orion is to review client accounts daily for tax-loss harvesting opportunities.
Second, many mistakenly think ETFs are the best replacement security. When most investors tax-loss harvest, they typically sell positions at a loss, reinvest the proceeds into an ETF to maintain market exposure, and then buy back into their portfolio after the 30-day wash sale period. Unfortunately, this approach can result in the creation of short-term gains if a client’s ETF replacement appreciates over the wash sale period.
A better approach is to replace harvested stocks with other stocks that have similar characteristics. For example, if a client harvests a loss in a large automotive stock, rather than buy an index ETF, a more efficient choice would be to purchase a different automotive stock in the index.
WSR: Besides tax-loss harvesting, what benefits can advisors and their clients get from custom indexing? How can advisors use custom indexing within a client portfolio?
Rosenberger: Custom indexing can provide advisors and clients with many other benefits, including the following:
Tax Transitioning – The technology used for custom indexing can also be used to tax transition portfolios over multiple calendar years. This is particularly helpful for advisors growing their book of business by bringing on new clients and for investors who want to make changes to their portfolio, but don’t want to realize a large amount of capital gains in one calendar year.
Capital Gains Budgets – Custom indexing allows investors to establish a limit on how much capital gains can be realized in any given calendar year. This is a great way to create more certainty around a client’s potential tax liability.
ESG/SRI/Faith-Based – Investors are increasingly looking to align their portfolios with their personal ethics. Custom indexing allows investors to exclude specific companies as well as tilt more towards companies that align with the client’s personal preferences.
Apply Investment Tilts – Currently Apple makes up a larger percentage of the S&P 500 than the entire energy sector. Many clients ask about tilting more towards the energy sector as a means of hedging against higher inflation. For clients who want to tilt their portfolios in a slightly different direction than the traditional market-cap weighting, custom indexing gives them that flexibility.
Janeesa Hollingshead, Executive Editor at Wealth Solutions Report, can be reached at firstname.lastname@example.org