Tax-aware investing for institutional portfolios

Key Takeaways:

• Taxes are now a core driver of institutional outcomes, not a secondary consideration
• Tax alpha is consistently available. Direct indexing helps create it, while active tax overlay helps ensure it is not lost through inefficient implementation
• The real advantage comes from continuous, system-driven execution. Tax-aware processes should be embedded into an OCIO model

For a long time institutions treated tax-aware investing like a retail conversation; helpful for individuals, interesting for private wealth, but not front and center for institutions.

That viewpoint is now too narrow.

If you manage a taxable institutional portfolio, taxes are no longer just a footnote, and constitute a key part of the organization’s return stream. Taxes now deserve to be managed with the same discipline as risk, liquidity and tracking error.

The conversation is no longer whether institutions can benefit from tax-aware investing. The question is when to start and how to do it. We believe the best approach is to simply make it part of your OCIO service.

Tax drag doesn’t show up in a performance headline, but it does everywhere else. It shows up in realized gains, dividends, and turnover — it’s in the mismatch between what a portfolio earns before tax and what the organization keeps afterwards.

Drag is not rare and is built into normal market behavior. Even in strong equity markets, many stocks go down at some point during the year, which creates opportunities to harvest losses.

The evidence is blunt: in most years, a large share of stocks spend time below their starting point, even when the index itself ends the year higher. That means tax alpha is not an exotic, once-in-a-decade opportunity. It is often sitting there in plain sight, waiting to be harvested.

One of the biggest sources of confusion is that tax management gets used as if it were a singular project. It is not. At a high level, there are two different jobs to be done.

First is direct indexing. This is about building a separately managed account that tracks an index while owning the underlying securities directly. That matters because the investor, not the fund, owns the tax lots. The investor can harvest losses at the security level, offset gains elsewhere, and maintain a highly customized implementation.

Second is active tax overlay. The goal is not to replicate an index, but to make an active public equity portfolio more tax efficient by coordinating trading, managing gains and losses, and reducing avoidable tax friction across the entire portfolio. Centralized trading, wash-sale control and lot-level decisions are core to that process.

The distinction between these two processes matters. Direct indexing is about creating tax assets, whilst active tax overlay is about making the assets you already own work harder after tax.

Tax-aware investing sounds elegant in a pitch deck, but in practice, it’s a grind. To do well, requires a tax-smart OCIO provider with the capabilities to combine portfolio construction, trading, tax accounting and implementation discipline. The key processes includes: tax-loss harvesting, wash-sale minimization, holding-period management, tax-smart turnover, transition management and optimal tax-lot selection.

Best-in-class OCIO providers will be able to run the tax process continuously, not sporadically. They will monitor portfolios on an ongoing basis, identify opportunities as markets move, and implement trades with enough precision to preserve the tax benefit without losing the intended portfolio exposure.

It’s accurate to say that direct indexing tracks an index, but the point is not to mimic an ETF in a more expensive wrapper, it’s to create control. Control over customization, over tax lots, over transitions, and over when and how losses are realized. The investor owns a sample of the index, can customize holdings, and can use tax-loss harvesting to offset gains elsewhere in the portfolio. That flexibility is the real product. 

If direct indexing is about tax alpha, active tax overlay is about not giving it away. An active portfolio can be very good before tax and still disappoint after tax, if turnover is high and the implementation is uncoordinated. Tax-managed implementation materially improves outcomes by reducing capital gains and dividend drag, especially in higher-turnover portfolios.

This matters for institutional investors because it reframes a familiar trade-off. The choice is not simply active versus passive. It is whether the portfolio has been built to support the tax economics of the strategy being used.

One of the most important factors is also one of the most overlooked: tax management should be year-round. Not seasonal. Not reactive. Not something you remember in December.

Even in years when markets are broadly up, there are still plenty of intra-year declines, and therefore plenty of opportunities to harvest losses. That constant, opportunistic harvesting can accumulate meaningful tax assets over time, which is why the best implementation systems look at the portfolio continuously to catch the volatility when it appears.

Tax-aware investing does not usually sell itself with a single dramatic story. It is iterative and technical. It asks the investor to care about the thing that is easy to ignore: what happens after the trade, after the gain, after the loss, after the year ends. But that is exactly why it is valuable. When a strategy can improve after-tax outcomes without requiring a wholesale rethink of the investor’s broader policy goals, it deserves more attention.

The uncomfortable truth is that many institutional portfolios are still managed as if taxes do not matter enough to redesign the implementation. Data shows that a wide range of taxable institutional pools can benefit from tax-aware direct investing, including corporate asset pools, endowments, captive insurance pools, nuclear decommissioning trusts, non-management VEBAs and more.

The opportunity is broader than many institutional investors realize and impacts any entity where taxable gains and losses flow through the economics of the portfolio.

Tax-aware investing for institutions is not a niche product and not a retail idea in institutional clothing. It is a portfolio implementation discipline.

For taxable investors, the opportunity comes from combining two things: direct indexing where the objective is to create tax assets, and active tax overlay where the objective is to make existing active portfolios more tax efficient. Both depend on centralized trading, lot-level precision, and a willingness to manage the portfolio across the full year, not just at the end of it.

Best-in-class OCIO providers will be able to deliver that combination because they can connect tax management, portfolio construction and trading in one operating model. For taxable institutional investors, that connection is where the real upside lives.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.