When it comes to investing, tax efficiency is a critical, yet often overlooked factor. Preserving wealth is not simply about earning strong returns–it’s about keeping as much of those returns as possible after taxes. While index funds, especially mutual funds and ETFs, are often celebrated for their tax efficiency, a closer look reveals that these vehicles may not be the best option for tax-sensitive investors. Direct indexing, by contrast, stands out as the “holy grail” for those seeking optimal tax efficiency. The Phantom Gains Problem in Mutual Funds One of the biggest misconceptions is that mutual funds, including index mutual funds, are tax-efficient by design. While their passive management leads to lower turnover and fewer capital gains distributions than actively managed funds, they suffer from a significant flaw: phantom gains. Phantom gains occur when a mutual fund distributes capital gains to investors–even if they haven’t sold shares. This can happen because mutual funds operate as pooled investment vehicles, meaning when the fund manager sells securities to meet redemptions, for example the resulting gains are passed along to all investors, regardless of individual transactions. You could