This year, with the collapse of Silicon Valley Bank, the U.S. banking sector skewed the overall loss numbers on the S&P 500.Spencer Platt/Getty Images
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Direct indexing may not be accessible in Canada but its tax benefits have some industry watchers examining the possibilities.
On a direct indexing platform, if a client wants to own a particular benchmark such as the S&P 500, the client would hold individual securities instead of purchasing units of an exchange-traded fund (ETF) or mutual fund, says Manmeet Bhatia, president and chief executive officer of Fiduciary Trust Canada, part of Franklin Templeton, in Vancouver.
“The systematic tax management opportunities available through direct indexing versus pooled investments represent a key advantage for private wealth portfolios,” Mr. Bhatia says.
“Canada faces some of the highest personal tax rates among G7 countries. Thus, the ongoing need for tax management is paramount as aggregate wealth is accumulated and passed on.”
Tax-wise, that means investors would be able to buy and sell individual securities within customized portfolios, crystallizing gains or losses to target specific taxation goals, he adds.
For example, investors could harvest losses in a particular company that’s underperforming while holding onto the rest of the index – something they can’t do with a mutual fund or ETF. That’s because direct indexing provides the ability to swap individual investments, says Chris Loveless, principal and president at O’Shaughnessy Asset Management LLC, a Franklin Templeton subsidiary, in Stamford, Conn.
Mr. Loveless points to 2020, a year when the average harvested tax alpha was around 650 basis points or 6.5 per cent of the value of an account. This year, with the collapse of Silicon Valley Bank, the U.S. banking sector skewed the overall loss numbers on the S&P 500. Having the opportunity to sell just the bank securities of the index improved the overall tax alpha, he notes.
“The U.S. tax system gives you the ability to select individual lots that give you more options over time of what might be at a loss to harvest,” he explains.
U.S. investors, regardless of where they live, can take advantage of direct indexing products if they work with a U.S. advisor. Matt Carvalho, chief investment officer at Cardinal Point Wealth Management ULC in Toronto, works with cross-border clients. He cites the example of an American holding two banks within a direct indexing structure – one does well and the other poorly. The client wants to reallocate the poor-performing one to another bank and still have the same exposure to financials.
“You’re able to tax loss harvest that loss at the time and then be reinvested into a similar type of exposure,” he explains. “That way, if an area rebounds, you are still able to participate in that.”
The role capital gains play
Compare this bank stocks scenario to Canada but in a situation in which the client has been holding them for several years. Selling a position requires a calculation of the adjusted cost base and then paying a capital gain of 50 per cent. He finds what can happen after an investor holds an investment for a long time is they decide not to sell it because of the potential of incurring significant capital gains, and can end up with a portfolio that no longer resembles the broad market.
“They’re almost kind of stuck in a position in which they can hardly make any changes, or advisors have to discuss how much investors want to realize in taxes this year,” Mr. Carvalho says.
He notes that he sees an appetite for direct indexing in Canada based on the portfolios he serves. While the number of advisors and firms using individual stocks is shrinking due to the popularity of ETFs and index funds, he says some clients still prefer individual holdings.
If direct indexing comes to Canada, he envisions the ability to donate individual stocks as they go up in value as a more common strategy.
“When you have something that has done extremely well over a recent period of time, you can handpick those pieces to donate and get the biggest bang for your tax dollar,” he says.
Franklin Templeton, which offers direct indexing to U.S. investors, is looking for a custodian to bring the technology to Canada. The company believes the concept might be a year or more away from heading north.
“I anticipate seeing a democratization of direct indexing where mass affluent clients are able to efficiently utilize the programs,” Mr. Bhatia says.
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