The Error of Tracking Error: Why Active Indexing Makes Sense

Abstract

Direct indexing is an excellent tool for improving after-tax returns for taxable clients. However, the predominant approach to doing this, where tracking error is minimized and any possible tax benefit is constrained, may be sub-optimal. Focusing too much on tracking error can lead to missed opportunities to add after-tax value. The best outcome for clients is to maximize their after-tax return/wealth, which may require taking on higher levels of tracking error. Based on 20 years of simulated portfolios, the authors found that higher active risk can potentially provide more tax alpha without sacrificing pre-tax performance, and that it is most beneficial in years with large drawdowns and during the earliest years after inception. When investors choose direct indexing providers, it is important to take a holistic view of their risk tolerance and investment horizon, and of the providers’ investment process—particularly how loss harvesting is implemented, how risk is managed, and how the strategy performs during large drawdowns. TOPICS: Mutual funds/passive investing/indexing, wealth management, portfolio construction, performance measurement Key Findings ▪ Systematic tax loss harvesting contributes significantly to clients’ after-tax wealth without compromising pre-tax performance. Tax alpha is often highest during the early years after inception, stabilizes as portfolios mature, and persists over an extended period of time. ▪ Higher active risk provides more opportunities to harvest losses. The value-add is usually greatest in years with large drawdowns and at the earliest stage of portfolios, when higher active risk is permitted. ▪ Tax managed portfolios tend to tilt positively to momentum and growth factors, and negatively to size, value, and dividend yield factors. The magnitude of active factor exposure is modest, however, and often not of real concern.