Direct indexing through a separately managed account is currently one of the fastest-growing investment strategies in the United States. This solution can be especially effective for those with concentrated company stock positions.
The approach allows investors to replicate the performance of a specific index while maintaining control over the individual securities. To achieve this, an automated program will systematically buy and sell the individual stocks that make up an index rather than simply purchasing the index as a whole via an exchange-traded fund or mutual fund.
Direct indexing has long been an effective strategy for ultra-affluent individuals and families. However, recent technological advances have now made this attractive solution available and affordable to investors of all levels. According to Cerulli Associates, direct indexing through SMAs has been growing at 12% annually, with total assets projected to reach $2 trillion by the end of 2024.
While some have labeled ETFs as 'the single most disruptive trend within the asset management industry over the last 20 years,' direct indexing seems likely to take over that spot.
Direct indexing has several significant benefits for those with concentrated company stock positions.
Customization, Diversification and Risk Management
Direct indexing allows investors to customize their portfolios based on their preferences and investment goals. Unlike traditional index funds or ETFs, which are fixed and cannot be altered, direct indexing provides the flexibility to exclude specific stocks or sectors from the investment portfolio. This customization allows investors to align a portfolio with their needs and risk tolerance.
Direct indexing can also enhance the ability to achieve diversification within a portfolio containing a concentrated stock position. Holding a significant portion of one’s wealth in a single stock can expose that individual to additional risk. Using a direct indexing approach, investors can spread their investments across a broader range of securities, reducing the impact of any single stock’s performance on their overall portfolio. This diversification can help mitigate risk and provide a more balanced investment approach.
The de-risking process typically involves removing the company stock from the separately managed account. This prevents unintentionally adding to an already concentrated position. For example, Microsoft is currently the highest-weighted stock in the S&P 500, comprising 7.1% of the index. When a Microsoft employee invests in the S&P 500 index, 7.1% of the purchase would be Microsoft stock. Not only would they be adding to an already concentrated position, but they would also, in effect, be overpaying for the stock in the retail market rather than receiving it at the discounted price internally through stock options or their employee stock purchase program. Imagine a dairy farmer who can produce a gallon of milk for $1. Why would he pay $3 for the same gallon at the supermarket?
In addition to removing a specific company stock from the customized index, investors can remove those securities with the highest correlations to the concentrated position or even reduce exposure to the entire sector. Going back to the prior example, a sensible approach might include dialing back overall tech exposure since Microsoft is highly correlated with the whole technology sector.
Tax Efficiency through Tax-Loss Harvesting
For many, tax-loss harvesting is probably the most attractive feature of direct indexing and, if done correctly, can potentially boost annual returns by 1%-2%. By owning individual stocks instead of broad indexes, investors can selectively sell those securities trading at a loss to offset current or future capital gains. Additionally, direct indexing allows for more control over the timing of the realization of capital gains, enabling investors to defer taxes until a more opportune time.
Tax-loss harvesting offers even greater value for those with concentrated company stock positions, as the harvested losses can be used to offset realized gains resulting from the scheduled selling of appreciated company stock. Studies show loss harvesting is most effective when new money is continually added to the portfolio. Therefore, a strategy that directs the proceeds from company stock sales back into the direct index can continuously fuel the tax-loss harvesting process and maximize its effectiveness.
Summary
Holding a concentrated company stock position has proven to be an effective way for employees to build wealth and increase retirement assets. It also benefits the organization by keeping its employees more closely aligned with company performance by having “skin in the game” through stock ownership.
For those carrying a concentrated position, rather than worrying about having “too many eggs in one basket,” a better approach may be to focus on creating a basket that protects those valuable eggs and helps maximize their future value.
Direct indexing presents a compelling investment strategy for individuals with concentrated company stock positions by offering diversification, tax efficiency, customization, and enhanced performance potential. With recent technological advancements, lower costs and increased availability, direct indexing has become a solution that all those with concentrated company stock positions should, at the very least, explore.
Jason Chalmers is a Director at Cohn Financial Group, a division of Gallagher.