Direct Indexing: What You Need to Know

Direct Indexing: What You Need to Know

April 30, 2024

This article will discuss the concept of direct indexing and explain why an investor may choose this approach over other separately managed account strategies, a mutual fund or an exchange-traded fund (ETF).

Direct indexing is a portfolio management solution that allows an investor to track a benchmark index with a basket of individual equities. Unlike an ETF which is only one security, this basket may hold hundreds or in some cases thousands of different equities held in similar weighting to the underlying benchmark index.1 This approach offers more flexibility, customization, and unique benefits than a traditional index solution. Due to the number of equity positions required in this type of account, the minimum investment amount can possibly be a barrier to entry.2

One of the main benefits of a direct indexed account is tax efficiency by utilizing tax loss harvesting. Broadly defined, tax loss harvesting involves selling investments that have decreased in value to eliminate or greatly reduce capital gains exposure on the sale of appreciated securities. For purposes of this discussion, we will assume there are no wash sale implications.3 Without a well-thought-out plan in place, selling investments that have declined in value and leaving the proceeds in cash carries a great deal of risk, namely the opportunity cost of future gains. The way to mitigate this risk is buying a similar, but not identical security to replace the investment sold at a loss. The goal is to recognize the loss but keep the investment exposure essentially unchanged. When using a direct index approach, an investor can realize losses whether the overall market is rising or falling. Being able to create tax efficiency in a rising market environment is a powerful investment tool.

Why go to all this effort? A simplified example will show the power of tax loss harvesting. Assume an investor has a position in ABC Corporation with an unrealized gain of $100k. If the position is sold the investor now has a capital gains tax of $20k due when filing the tax return.4 Now assume this same investor has accumulated realized capital losses of $100k. These losses can be used to offset the gain, so now the investor has a $0 tax bill.

Another example will show how the process works in practice. Sticking with ABC corporation, assume this time a different investor holds the position but has a $100k unrealized loss. The position can be sold and immediately replaced with XYZ Corporation (a similar company to ABC). The investor has now locked in a loss that can be used to offset future gains while keeping the investment exposure very similar. If you apply this concept across a large number of equities one can closely replicate a benchmark index while capturing a significant tax advantage. This creation of “tax alpha” can be a significant source of after-tax return. Said another way, an investor can keep more of their hard-earned wealth without sacrificing an efficient and well-designed portfolio.

There are several other attractive features of direct indexing, including reducing exposure to a large position with unrealized gains or expressing personal values and beliefs through security selection.

A new portfolio constructed of one equity position with long-term gains and cash can be used to generate tax losses to gradually reduce the large position with little or no tax impact. The cash can be used to create a personalized direct index and the tax losses that are generated can be used to offset the gains created by reducing exposure to the large position. Over time (sometimes very quickly) the large position is reduced and included in a diversified portfolio.

A direct indexed account can also create a portfolio that matches an investor’s personal values; however, care must be taken to ensure that the personalized index doesn’t deviate too far from the benchmark if the ultimate goal is targeting performance tied to the overall market. For example, if an investor wanted to eliminate technology from a portfolio, they would be taking a significant risk that the investment performance may deviate a significant amount from the broader market. There is a tradeoff between tracking error risk and expressing values and beliefs in an investment portfolio.

Every investor has a unique set of goals and challenges. Direct indexing is a flexible and efficient way to customize an investment portfolio while increasing after-tax return.

1 Discussion of the number of securities in a basket is beyond the scope of this article.

2 Many direct index accounts require a minimum investment of $250,000 or more.

3 The wash-sale rule prohibits selling an investment for a loss and replacing it with the same or substantially identical investment 30 days before or after the sale.

4 Assumes capital gains tax rate of 20%.