Direct indexing is an exciting investment method that will likely get much more attention in the near future. This is because direct indexing offers unique advantages not available through traditional ETFs or mutual fund structures – particularly around tax management and investment personalization.

According to a Cerulli report, direct indexing will continue to outpace mutual fund and ETF growth over the coming years due to its advantages. Following is what you should be aware of about the benefits of direct indexing.

What is Index Investing?

Investors, most likely including you, now commonly use index mutual funds or index Exchange Traded Funds (ETFs). Index funds replicate an index such as the S&P500 by investing in each of its components. In the case of the S&P500, it means buying 500 stocks with the same structure as the index itself.

Because an index fund mimics the index exactly, it allows an investor to match the performance of the index closely . Index funds are different from active funds that try to beat the index. Although we all prefer to beat the index, evidence shows that professional stock fund managers are usually unable to do so consistently on a risk-adjusted basis.

What is Direct Indexing?

With direct indexing, investors own each of the individual stocks that make up an Index rather than owning an index mutual fund or index ETF .

The goal with direct indexing is similar to the goal of an index ETF: achieve performance tracking the index. However, direct indexing also allows investors to personalize their investments and receive greater tax advantages from holding individual securities within their accounts .

Direct indexing has long been a staple of high-net-worth clients’ strategies. It makes sense, considering its numerous advantages – particularly regarding taxation. However, historically, the strategy was cumbersome because of the number of required trades and the associated trading costs. As a result, it was only cost-effective with very large accounts.

However, modern investment industry developments that reduce costs, such as no-commission trading, fractional share trading, and the availability of large-scale computing, are making it possible to offer direct indexing to a larger public.

Reduce Tax Bills

Direct indexing portfolios offer greater flexibility for tax loss and tax gain harvesting . That involves selling low-performing securities at a loss to offset capital gains in other securities. We are already familiar with market downturns that can create wide losses across a portfolio. In this unfortunate circumstance, loss harvesting is just a way to make lemonade from lemons.

Many people don’t realize that even in a rising market, many individual stocks inside an index will post negative returns . One of the reasons we use index investing is because it is challenging to identify beforehand which stocks will go up and which will go down.

Direct indexing tax loss harvesting allows investors to take advantage of the fact that many positions are going down even in a rising market . Harvesting these losses and a comparable gain makes a rising portfolio more tax efficient by reducing taxable profits.

According to Vanguard’s recent research, this could translate into significant after-tax returns of 1% or more. Other studies have estimated that the benefit could be up to 3%.

An academic study from Professor Lo et al. at the Massachusetts Institute of Technology examined historical returns over the past century. It concluded that from 1926 to 2018, direct indexing could have increased after-tax returns from 0.51% to 2.13%, with an average of 1.08% annually. So, is direct indexing worth it? When you consider the power of compounding, this makes it an enormous advantage for long term investors.

One percent may not sound like a lot. The results will vary for everyone depending on their investments, tax situation and other factors. It should be noted that direct indexing providers will implement differently, leading to different results .

Better Asset Allocation

With a mutual fund or ETF, the investor indirectly owns all of the index’s components, thus overlooking the issue of overexposure to other securities .

For example, an investor may already have a large position in a component of the index such as the S&P 500, for example, TSLA or AMZN or any of the 500 stocks that make up the index. Or the investor could have RSUs or stock options from their employer. A financial planner might tell them they are already overexposed to these individual securities, thus exposing them to greater risk.

With the flexibility allowed by direct indexing, the investor’s portfolio can build around these securities and exclude them from the indexed portfolio. That allows better asset diversification and reduces the risk of being overexposed to specific securities.

Pinpoint Personalization

With direct indexing, investors have the freedom to customize their portfolios by holding securities instead of an index fund, which is not customizable .

For example, portfolios can be tailored to ESG factors or exclude securities that don’t match investor values while keeping a more fully diversified portfolio than is practical with simply buying individual stocks.

We should note that personalization can cause a portfolio’s performance to diverge from its index. The original reason to invest in an index was to benefit from diversification. Therefore, personalizing a portfolio will necessarily result in performance divergence . Investors need to reflect on their own risk tolerance and expectations and how they may or may not match with a personalization strategy.

Direct Indexing – Is it Right For Me?

Direct indexing can offer the benefit of harvesting capital gains and losses, potentially resulting in a meaningful increase in performance . Because the IRS limits the amount of capital losses that we can claim for tax purposes, the full benefit of harvesting capital losses comes with harvesting capital gains to offset the losses.

For example, you have no net gains or losses if you sell security A at a loss of $2,000 and security B at a gain of $2,000. Balancing the two effectively reduces taxable capital income and, therefore, capital gains taxes.

Direct indexing also presents more complications than a portfolio using funds since individual securities can be held and traded for tax loss harvesting – creating additional transactions to consider.

According to various studies, direct indexing can result in a better Return On Investment, primarily through tax advantages . So whether saving for retirement, recovering from divorce, or simply accumulating wealth outside of retirement accounts, direct indexing performance advantages are bound to intrigue investors.

Tax harvesting is not a new concept. What is new is the ability to use investment software to do it systematically and at scale. Other recent innovations that facilitate direct indexing also include fractional share trading and no-cost trading. The first allows rebalancing to match the index instead of approximating it. The latter enables implementation of the strategy without concern for trading costs dragging performance.

These advances in technology make direct indexing accessible to retail investors.

Can you use better performance in your portfolio?

If not, that’s fine.

But if you do, reach out! Visit Insight Financial Strategists,  or schedule a complimentary call

Chris Chen CFP


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