Direct indexing SMAs, which have traditionally focused on large cap equities, can offer additional benefits when applied to mid cap, small cap, value or growth indices.
In Brief
- Tax-smart direct indexing strategies have typically been associated with large cap core equities, but mid cap and small cap indices could create more opportunities to harvest losses.
- The higher volatility of stocks in mid cap and small cap indices, in addition to lower index concentration, provides greater opportunity to harvest losses in a risk-controlled manner.
- Value and growth indices offer distinct performance cycles, which can be beneficial from both investment and tax perspectives.
- Investors may want to consider the diversification benefits, including more potential for tax-loss harvesting, from adding allocations outside of U.S. large cap stocks.
Direct indexing strategies offer investors the opportunity to achieve index-like exposure while simultaneously benefiting from tax-loss harvesting—helping them build and preserve wealth. However, the outcomes for both investment performance and tax savings can vary depending on which index a direct index separately managed account (SMA) tracks.
Traditionally, the strategy has been associated with large cap core equities, but understanding the tax-loss harvesting potential across other parts of the equity market can help investors optimize a direct indexing strategy within a tax-sensitive portfolio.
More movement, more opportunity
Indices made up of small cap and mid cap stocks often experience high volatility for a variety of reasons: increased economic sensitivity, higher growth potential and lower efficiency. This heightened volatility can offer both the potential for higher returns and more opportunities to to harvest losses.
Over the past decade, the S&P MidCap 400 Index and S&P SmallCap 600 Index have exhibited higher volatility compared to the S&P 500 index at the index level (Exhibit 1). More importantly, when looking at volatility at the individual stock level, the median stock for the mid and small cap indices exhibited realized volatility of 33% and 40%, respectively, vs. 28% for the S&P 500, on average over the last 10 years. The trend persisted in high-volatility years, such as 2020, and more subdued years, like 2017.
Increased volatility at the stock level in small cap and mid cap indices creates more opportunities for stock-by-stock tax-loss harvesting, which is an inherent advantage of direct indexing.
Smaller cap indices also tend to have a higher percentage of stocks with negative returns at any given point. For example, in seven of the last ten calendar years, the S&P 500 has had a smaller percentage of stocks down 5% or more at the end of each year compared to the S&P 400 and S&P 600 (Exhibit 2).
Index concentration can cap opportunity at the individual stock level
It’s well known that the S&P 500 Index has a concentration problem—and that impacts the tax-loss harvesting opportunity set for direct index SMAs.
On the surface, more stocks in an index generally means more opportunity for tax-loss harvesting. That’s because unlike pooled vehicles, such as ETFs or mutual funds, direct indexing enables loss harvesting at the individual stock level, rather than at the overall index level.
Concentration, however, can add nuance to—or break—this relationship. For example, the S&P 500 is comprised of around 500 individual stocks but the top 10 index holdings make up approximately 38% of the index's market capitalization*. That means an investor would have to take significant single-stock risk when harvesting losses in these names, which requires temporarily selling out of them and exposes the account to the risk of missing a recovery in those positions. Therefore, loss harvesting that can be achieved on this portion of the index is limited when doing so in a risk-managed way.1
The “effective number of stocks” is the number of stocks that “effectively” drive an index rather than the total number of stocks within an index. The lower the effective number of stocks, the higher the concentration. Over the last 10 years, the effective number of stocks in the S&P 500 has dropped from 144 at the end of the 2015 to less than 50 at the end of 2024; a smaller proportion of stocks are driving returns – and losses.
Importantly, not all U.S. indices have experienced the same levels of concentration as the the S&P 500 (Exhibit 3). Over the past decade, the S&P MidCap 400 Index and S&P SmallCap 600 Index have maintained higher and more consistent effective numbers of stocks than the S&P 500, presenting more diversified sets of stocks for tax-loss harvesting in a risk-managed way.
Consistent, strong performance can reduce opportunities for tax-loss harvesting
Strong and sustained performance from the underlying stocks in an index can mean there are naturally fewer opportunities to harvest losses on those positions. For example, looking at rolling 10-year performance periods, the S&P 500 Growth index outperformed the S&P 500 Value Index in 14 of the last 22 periods and in every 10-year period since 2003. This performance advantage has resulted in less opportunity to generate tax alpha from the S&P 500 Growth index vs. the S&P 500 Value index during this timeframe, albeit with higher returns (Exhibit 4). As performance regimes shift, so does the opportunity for tax-loss harvesting.
The case for diversification in direct indexing strategies
Does the better opportunity set for small cap and mid cap indices translate into loss-harvesting outcomes? We simulated a simple, monthly tax-loss harvesting approach on both the S&P 400 and S&P 600 indices, looking at 10-year vintages with starting years from 1993 to 2014.2
The results confirm that the lower concentration and higher volatility of mid cap and small cap indices vs. large cap indices can create more opportunities for tax-loss harvesting. Over periods of 10 years, both the S&P 400 and S&P 600 generated additional annualized tax savings compared to the S&P 500 and S&P 1500 (Exhibit 5).
No asset class can do it alone
U.S. large cap equities tend to play a significant role in most portfolios, but relying on just this asset class can put a portfolio at risk. A small cap or mid cap allocation can play a diversifying role in an overall portfolio while also providing an unique opportunity for tax-loss harvesting. Investors can mitigate risks and optimize returns, building a well-rounded investment strategy from both a pre- and post-tax perspective.
Over the last 15 years, value, growth, mid cap and small cap have all enjoyed periods of higher annual returns relative to the S&P 500 (Exhibit 6). The S&P 500 has outperformed smaller cap indices in recent time frames, however, looking at 10-year investment periods starting in 2004 confirms this has not always been the case (Exhibit 7).
Investors thinking about allocating to an equity sleeve within a portfolio should consider a variety of factors. The heightened volatility associated with U.S. small cap and mid cap stocks may not suit every investor's risk tolerance. However, it is important to remember past years and market regimes when large cap stocks were the laggards rather than the leaders. The potential for increased tax-loss harvesting from these allocations can help investors retain more of their earnings, enhancing after-tax returns. For some investment objectives, investors may need exposure to a certain style box, regardless of how that may impact tax-loss harvesting potential. However, by leveraging the unique characteristics of each index, investors can optimize their portfolios for both investment growth and tax efficiency.