Direct indexing’s popularity has soared, with assets invested in direct indexes exceeding $260 billion at the end of 2022. This approach, which involves investing in the individual securities constituting an index rather than the index fund itself, offers a unique combination of benefits. Not only does it aim to allow investors to closely replicate the performance of an index, but it can also significantly enhance tax efficiency.
Further, direct indexing provides a level of personalization far beyond the capabilities of conventional index funds, making it an increasingly attractive option for those looking to tailor their investment strategies.
Direct indexing is gaining traction, and rightfully so. Let’s examine some of this strategy’s more compelling tax benefits, in addition to customization and diversification.
Harvesting Losses Can Be Additive to Direct Indexing Returns
Direct indexing has certain advantages over off-the-shelf index funds, whereby investors hold a diversified basket of stocks but lack the ability to manage individual components for tax purposes. Through direct indexing, investors can sell securities that have declined in value to offset taxable gains elsewhere in their portfolio, potentially reducing tax liabilities and enhancing tax efficiency. This process is known as tax-loss harvesting and may help improve after-tax returns. However, it's important to navigate this strategy within the constraints of the wash sale rule, which prohibits claiming a tax deduction for a security sold in a loss if a substantially identical security is purchased within 30 days before or after the sale.
Consider an example where Microsoft is up 15% on the year, while another equity is down 20% with deteriorating earnings. By being invested directly into each stock rather than through shares of an index fund, investors have the ability to filter out poor-performing investments and, in turn, offset up to $3,000 of taxable gains or ordinary income. An investor utilizing a direct indexing strategy has the opportunity to divest the weak position at a loss, which may help offset any realized gains in Microsoft. Advisors who deploy this strategy can potentially strengthen client relationships and differentiate their practice, as evidenced by the following example where an extra 1% in tax alpha can equate to approximately 11 years of additional retirement distributions.
Reducing Concentration Risk
Another prime example of direct indexing’s potential advantages rests with company stock plans. An executive at a tech giant like Microsoft might accrue significant amounts of company stock over time, with a low cost basis. This can cause an individual’s wealth to be rather unbalanced, with a portfolio overweight in one position. Investors have the opportunity to balance this out through the use of direct indexing.
This might involve modeling a portfolio after an exchange-traded fund that counts Microsoft as its top holding. Through direct indexing, the holder of a large position in Microsoft would be able to mimic the fund’s structure while excluding their concentrated stock. This allows them to customize their portfolio to reflect the broader market exposure of an ETF, strategically avoiding additional investments in stocks where they already have significant exposure.
This strategy isn't just for executives holding significant company stock, either. Consider advising a client who took a position in Nvidia several years back. They’re likely sitting on substantial, unrealized gains thanks to the stock's remarkable performance. Direct indexing permits the client to track the broader market while opting out of further Nvidia purchases. This strategy facilitates portfolio diversification and enables them to strategically engage in tax-loss harvesting, potentially offsetting weaker stocks’ losses against the gains from Nvidia shares.
Maximizing Inherited Wealth Through Selective Loss Harvesting
Inheriting assets presents yet another opportunity for direct indexing, coupled with loss harvesting, to help reduce an investor’s tax bill. When someone inherits assets, they receive a step-up in the cost basis of those assets to their fair market value at the time of the original owner’s death.
This step-up in cost basis may reduce or eliminate any built-in capital gains tax liability. However, inheritors might still incur capital gains taxes on any subsequent appreciation of these assets. It’s advisable for them to review their portfolio to identify securities that have depreciated since the inheritance date. Once they’ve identified the “losers,” they can selectively sell individual securities with unrealized losses to offset any capital gains realized elsewhere in their portfolio.
Direct Indexing as a Competitive Advantage for Advisors
Direct indexing has earned a reputation as both a tax optimization tool and as a conduit for deeper client-advisor connections. By better aligning investment strategies with clients’ objectives, ethical considerations and risk preferences, direct indexing enables advisors to deliver tailored solutions that go beyond traditional investment vehicles.
Combining tax optimization with portfolio customization, direct indexing can serve as a differentiator for advisors aiming to elevate their practice in an increasingly crowded and competitive market. This can serve to showcase the advisor's commitment to delivering personalized, thoughtful investment guidance, while simultaneously providing a value-add to clients.
Nathan Wallace is a wealth manager at Savvy Advisors Inc. a digital-first platform for financial advisors that’s centered on modernizing human financial advice experience.