Envestnet Whitepapers

3 20241217-4105197 How Does Direct Indexing Fit In? Direct indexing is a form of passive, or systematic, investing that enables direct ownership of the individual securities that compose a benchmark. Unlike a mutual fund or an exchange-traded fund (ETF), it gives investors greater control over the portfolio and allows for tax-loss harvesting, customization around preferences, and other features. It is typically implemented by having the account initially invest in an optimized subset of the securities in an index, while also allowing for all securities in the index to compose a "buy list" when tax-loss harvesting is deployed. This allows the account to potentially "bank" losses while reinvesting proceeds in securities within that index. In a UMA, direct indexing works a bit differently. The direct indexing manager still optimizes the client portfolio using a subset of securities in an index. However, rather than having this subset of securities become a "buy list," the subset becomes a model that is delivered to the overlay for use as a sleeve within a UMA. A traditional direct indexing SMA, described above, typically employs aggressive loss harvesting to offset gains that the client may have with their other taxable assets. This approach might result in harvesting losses unnecessarily because the direct indexing SMA does not have a line of sight to the client's other taxable assets. It assumes every client prefers aggressive loss harvesting immediately. (Premature loss harvesting may lead to "portfolio lock," described in a later section.) Ultimately, a tax management approach used on only a portion of a client's taxable investment portfolio cannot consider the situation across the entire client asset base. The UMA "chassis," however, allows for a fully diversified portfolio of multiple asset classes to be part of a tax management strategy, enabling the entirety of an investors' taxable assets to be managed to a client-specific tax budget. The holistic tax overlay does not need to make assumptions and can be customized per client needs. Direct indexing does not have to be confined to stand-alone SMAs, however. It can be included as a sleeve within a UMA, making it an extremely valuable component within a holistic tax management solution. Holistic tax overlays, UMAs, and direct indexing can comprise key pieces of the financial puzzle for many clients, hence why we discuss them together. It is difficult to understand the overlay without first describing what generally lies underneath it. Implementation of the Holistic Tax Overlay The overlay is coordinated by a centralized manager to accomplish these key tax objectives: • Managing the account so that it is as close as possible to the target model from a risk perspective, as measured by tracking error • Adherence to client needs through personalized tax management • Diversifying concentrated portfolios in a tax-efficient manner • Minimizing realization of net short-term capital gains • Monitoring and generally avoiding wash sales • Aiming to meet client-specific long-term capital gains tax budgets • Reporting on the benefits of tax management at the client level Why is having a centralized overlay manager trading all the taxpayer's taxable securities important? It allows the investor to have greater control of their tax obligations by managing all their taxable assets to a specific tax budget, while also adhering tightly to the desired portfolio allocation. The overlay manager can additionally coordinate the harvesting of losses at the time the investor needs or wants to generate them, rather than aggressively loss harvesting when there are no gains to offset and potentially causing portfolio lock. All the tax overlay goals identified above may matter to HNW individuals and families because they are either tied to significant and likely sources of income taxes, provide deeper levels of personalization, or connect to overarching investment goals. In short, a holistic tax overlay can be viewed as a cornerstone of overall investment management and financial planning instead of as a niche tool that is simply "nice to have." Outsourcing the tax overlay to a third-party overlay manager also frees the advisor from time-consuming trading and rebalancing activities. On large, complex accounts, manual attempts to optimize tax efficiency are likely to require enormous effort. An overlay manager leveraging an algorithmic risk-based engine, meanwhile, can rely on a system that will never get tired nor have to juggle other demands. Advisors who implement holistic tax overlays for clients can focus on other aspects of their practices besides tax managing portfolios. How should tax efficiency inform how we approach asset allocation for taxable accounts? In taxable accounts, we should think about allocating to those vehicle and product types that provide the greatest flexibility from a tax management standpoint. The table below summarizes this concept. (Note that Fund Strategist Portfolios, or FSPs, are referenced in our table. FSPs are model-delivered, multi- asset class portfolios controlled by a single overall manager. These portfolios are typically comprised of individual mutual funds and/or ETFs. The differing approaches to asset allocation shifts within FSPs means that holistic tax overlays work more effectively with some FSPs than others.)

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