Aligning Tax Advantaged Solutions with Personalized Goals

What is Direct Indexing?

Direct indexing seeks to closely track the performance of a market index while creating tax savings to increase returns. Investors own individual securities in a portfolio via a tax-advantaged separately managed account ("SMA"). Holding individual securities rather than a single fund allows investors to customize their exposure to the initial index according to their needs while allowing for greater tax efficiency.

Direct indexing seeks to:

• Replicate the exposures of a benchmark while keeping tracking error in line with a specified target
• Employ tax-loss harvesting strategies that utilize losses to offset potential capital gains realized anywhere in a taxable portfolio
• Optimize portfolios sensitive to after-tax returns that can be personalized to reflect an investor's goals

Tax-Advantaged Investing

Enhanced After-Tax Returns

Direct indexing provides an enhanced ability to generate tax alpha, which optimizes after-tax returns. While alpha is a measure used to evaluate portfolio returns in excess of a benchmark index, tax alpha is a measure of after-tax account return that exceeds pre-tax return in excess of a benchmark. The example below illustrates the tax alpha that may be achieved by the growth of an initial investment over a 25-year period.

Assumptions: Initial Investment Amount: $1 Million | Annualized Equity Market Return: 8% | Dividend Tax Rate: 23.80% | Long-Term Capital Gains Tax Rate: 23.80% | Short-Term Capital Gains Tax Rate: 40.80% This sample provided does not reflect the investment results of actual securities and is not a guarantee of future results. Changes to the assumptions will drastically change the results. See complete methodology below. Chart Methodology: The sample provided assumes a starting basket of 300 equally-weighted hypothetical securities. Returns are randomly simulated monthly with the annualized mean chosen above and annualized standard deviation of 30%. It is assumed that the portfolio's 2% annualized dividend yield is subject to income tax and is reinvested monthly into a new tax lot. The "Passive" strategy simulates a buy-and-hold strategy over the investment horizon. The "Tax-Advantaged" strategy simulates a tax-loss harvesting strategy. In any period that a tax lot's cumulative loss exceeds 5%, the tax lot is sold, and the proceeds are immediately reinvested, plus any tax benefit, into a new tax lot. Tax benefit calculations assume that the capital gains offset by the harvested loss are 50% short-term and 50% long-term. The Monte Carlo simulation takes an average across 2000 iterations for each set of return, risk, and tax assumptions. The sample presented does not represent actual trading of securities and is not indicative of actual investment strategy performance. The impact of market factors is not included in this simulation which may cause the results to be over-or-under stated. This should not be construed as a representation that any account will, or is likely to, achieve profits, losses or tax savings similar to those reflected in this example.

Tax-Efficient Transitions of Appreciated Securities

Proper tax management is especially important when exiting securities with appreciated gains. When transitioning securities into a Direct Index SMA, the account can be funded in-kind without creating a taxable event. The tax management tools available through direct indexing can be used to achieve a tax-efficient portfolio transition and potentially minimize, delay, or avoid net taxes.

Personalization

Whether prioritizing traditional factors, risk management strategies, thematic positioning, or values-based investing, First Trust Direct Indexing provides a menu of 70 levels of customization. Advisors can completely customize their clients’ exposure to selected benchmarks based on their investment goals and personal values. For example, clients with already-substantial allocations to a particular sector may wish to include the securities from that sector that would otherwise be included in a benchmark, just as they may wish to exclude companies that employ practices with which they disagree.

Investment Process

First Trust Direct Indexing provides exposure to a variety of benchmarks through direct ownership of individual securities in a portfolio via a tax-advantaged SMA. These SMAs offer continual portfolio review with intra-day tax-loss harvesting to provide a greater ability to generate tax alpha. They can be customized based on factor tilts or personal values while keeping tracking error in line with a specified target.

Mutual Funds, ETFs, and Direct Indexing - What's the Difference?

There are many similarities among mutual funds, exchange-traded funds (ETFs) and direct indexing. Typically, investors use ETFs and mutual funds to gain indirect exposure to the securities in a benchmark. Although ETFs and mutual funds can deliver broad market exposure, direct indexing does so with a key difference: a portfolio can be tailored to an investor's specific needs and tax loss harvesting strategies. This portfolio of the optimal component stocks of a benchmark, held directly in an SMA, can be funded with either cash or with an existing portfolio of securities (in-kind), including appreciated stock, which provides the potential to create tax alpha beyond what ETFs and mutual funds may offer.

This summary is not intended to be tax or legal advice. This summary cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. This summary is being used to support the promotion or marketing of the transactions herein. The taxpayer should consult an independent tax advisor.

There are no guarantees to the effectiveness of tax alpha in minimizing an investor’s overall tax liabilities or to the tax results of any given transaction and the performance of an account may be negatively affected by tax gain/loss harvesting. Financial professionals should consult with a tax professional regarding the potential application of loss deferral regimes, such as wash sales and straddles, to any securities and potential transactions along with other securities and transactions in a broader portfolio.

First Trust Direct Indexing L.P. (“FT Direct Indexing”) is an investment advisor registered with the U.S. Securities and Exchange Commission. FT Direct Indexing is affiliated with First Trust Portfolios L.P. and is responsible for the day-to-day management of direct index SMAs. First Trust Portfolios L.P. is the marketing agent for the direct index SMAs.

FT Direct Indexing has entered into a contractual agreement with an affiliate, First Trust Portfolios L.P. and First Trust Advisors L.P. (jointly referred to as ”First Trust”), to solicit investment advisory services provided by FT Direct Indexing. Since FT Direct Indexing management fees are based upon a percentage of assets under management, the more assets under management, the higher fee income to FT Direct Indexing. In addition, since First Trust’s affiliate, First Trust Capital Partners LLC, owns FT Direct Indexing, First Trust will indirectly benefit from an increase in fees received by FT Direct Indexing. Due to such compensation, First Trust has an incentive to recommend advisory services of FT Direct Indexing, resulting in a material conflict of interest which should be considered when making a decision to engage FT Direct Indexing. First Trust will not be involved in the provision of services by FT Direct Indexing.