Many of your clients may be ready to embrace indexing, but transitioning from active investing into passive can carry potential tax consequences. Here’s why: to buy shares of an ETF, investors must sell their existing stocks, and in the process, they may be creating a substantial taxable event if the stocks are low basis.
Investors could be giving up a significant amount of their portfolio’s value to capital gains taxes before they even start on a new investing program. They face two painful choices: take a tax hit or continue in an investment strategy their advisor believes is not right for them.
There’s a better way to get on board with indexing.
Because Smartleaf’s Core Portfolio is based on direct indexing—investors own individual shares of the index they are tracking, not shares of a fund—we can include some or all of your clients’ appreciated stock holdings in the new strategy. No need to liquidate!
Consider this example: a client comes to you with a portfolio from another advisor that includes shares of Ford Motor Co. (F). After a review, you determine that a direct index portfolio is a better option. Though the direct index does not hold Ford, it does include General Motors (GM). Ordinarily, clients would be advised to sell all their shares, including Ford, to start fresh, even if it means incurring heavy capital gains.
Since Ford and General Motors are in the same industry, their stocks often move together. Therefore, clients could still get many of the same benefits with Ford, without the tax consequence of selling it. At Smartleaf, we may incorporate shares of existing holdings, if the tax benefits outweigh the risk consequences of keeping the existing security.
If investors do need to sell some stocks as they transition into Smartleaf’s Core Portfolio, we work with advisors to do it gradually and in the most tax efficient way possible. We recommend that advisors set a tax budget for their clients each year, which governs how we sell of securities through the transition process.
Naturally, a tax-sensitive approach to transitions is better for clients. There are also benefits to advisors:
Shows you are serious about investment expenses. Fees and taxes can take a heavy toll on investor returns. By moving into a lower fee product (direct indexing) while also minimizing the tax impact, you’re doing right by clients by keeping investment expenses in check.
Lets you exercise your best judgment. Advisors do not need to stick with strategies they no longer believe in order to keep taxes low.
Attracts new clients. Advisors can differentiate themselves with a tax-sensitive approach in a crowded market. New clients can be assured that transitioning will not be costly.
Learn more about Smartleaf Core Portfolios here.