Ethical Investing With A Tax Break

You can get a diversified portfolio that suits your values—and get a tax break out of it.

Adequate solution for the investor seeking a socially conscious portfolio: buy a fund.

Better solution for a lot of people: buy a whole bunch of individual stocks.

In a taxable account, the individual-stock portfolio has a big advantage over the fund. It creates opportunities for loss harvesting—that is, the plucking out of underwater positions to generate capital loss deductions. Funds can’t compete with that. If the whole fund goes down you can sell it for a loss, but the fund can’t selectively realize losses and pass those losses out to you.

Until recently, building a socially conscious portfolio out of individual stocks was quite impractical. That disability is rapidly receding, thanks to fractional shares, $0 commissions and a proliferation of ESG data. You can screen for acceptable stocks, place basket trades and maintain tiny positions.

“Technology has been an enabler for individual investors to become sustainable investors,” says Michael Jantzi, founder of ESG rating firm Sustainalytics.

At Fidelity Investments you can screen for companies that MSCI ranks as “leaders” on a composite ESG score and that also clear other hurdles, such as for market cap. You can make a basket out of tickers that pass muster, then place a basket trade to buy 50 stocks at a time—say, $500 of each. The fractional shares feature will be handy if Shopify (recent close, $677) or BlackRock ($738) ends up on your list.

Interactive Brokers, an online brokerage firm appealing to heavy trades, can do all that and more. In November it introduced a sustainable investing platform called Impact that allows customers to get for any stock a customized ESG view that is sensitive to their particular concerns (the long list of criteria includes fossil fuels, ocean life and animal testing).

You can use Impact to create a portfolio for basket trading or use it to scorecard an existing portfolio, flagging the stocks that ought to give you pause. Impact has an interesting swap button that allows you to simultaneously sell an offending position and invest the proceeds in a similar firm that has a better sustainability rating. Another Impact feature makes it easy to use highly appreciated positions for your charitable giving, yet another tax benefit to owning individual stocks.

Objective in all this, says Will Peterffy, director of ESG at Interactive Brokers (and the son of Interactive’s founder): “Have your financial decisions match your values.”

Today, the homemade ESG portfolio is for committed do-it-yourselfers only. It takes a fair amount of work to assemble a large list of stocks, monitor it for loss harvesting potential and place trades. It’s likely, though, that the tools will get sharper as brokers compete for the assets of investors who are sensitive to both sustainability and taxes.

If the process intimidates you, consider hiring a firm to manage your portfolio. We’re talking here about what is called direct indexing, the process of creating a collection of individual positions that mimic an index fund.

Direct indexing used to be the plaything of the rich. They’d send a few million dollars off to a firm such as Parametric (now part of Morgan Stanley) or Aperio (now part of BlackRock) and get a semi-automated portfolio of several hundred stocks chosen to roughly track a stock index. Minimums were high because, in olden times, positions needed to be made out of whole shares.

Now the doors on this scheme are being opened to the masses. Wealthfront (soon to be part of Swiss bank UBS), one of the pioneers in robo-advising, has a direct-indexing option for accounts as small as $100,000. It has the same tax advantages that big investors get, and customers can fine-tune their portfolios by excluding offending companies.

Fidelity Investments is planning to soon offer a similar service called FidFolios. You can use it to get stocks pre-screened on environmental and other criteria and then, if you want, apply additional exclusions, ticker by ticker.

FidFolio’s minimum ante is only $5,000; the annual fee 0.4%. Put one of these portfolios in a taxable account and there’s a decent chance you can earn back the entire management fee with tax savings, at least in early years.

If the market continues marching upward, you will, after a few years, wind up with nothing but gain positions. At that point the loss harvesting is over, but the winners become excellent vehicles for charitable giving. Provided that a position is more than a year old, the charitable deduction is figured on the current market value but the gain is never taxed.

Now here are a few caveats about ESG direct indexing.

—Basket trades are available only for market orders. In a thinly traded stock, a market order is an invitation to be gouged by the market maker. Stick to liquid stocks.

—While commissions are free, bid/ask spreads are not. You’ll lose at least a penny a share in a round-trip trade.

—You will encounter some stumbling blocks in massaging stock lists. While exporting a watch list or list of holdings to a spreadsheet is easy, going the other way may not be. It appears that uploading tickers from a spreadsheet to a brokerage account is feasible at Interactive but not at Fidelity.

Fidelity limits baskets to 50 stocks; Interactive does not. Moving the results of a stock screen into a basket is awkward at Fidelity (tickers must be checked off individually) but not at Interactive. In one respect Fidelity makes life easier for do-it-yourself indexers: It permits the export of ESG scores, while Interactive does not.

It might make sense for you to have two brokerage accounts. Use Fidelity’s to capture ESG scores along with fundamental data. Use the resulting spreadsheet offline to create a buy list. Then import that into Interactive and trade there.

—Because of licensing rules by index providers, your broker might not permit you to copy an index (such as the S&P 500) into a file. Use a workaround. Create an index lookalike by screening on market capitalization and trading volume.

—The tax benefit from loss harvesting depends on your tax situation. Boosters of the strategy who predict a benefit of up to 2% a year in early years assume that some of the losses will be used to offset short-term gains taxed at high rates. But what tax-wise investor is foolish enough to have any short-term gains at all? You can apply $3,000 a year of capital losses against your salary. But most of your losses may come into play only years later, when you are offsetting the gain from the sale of a house.