What’s A Direct Indexing Strategy?

Direct Indexing – Your Top 6 Questions Answered

What is it?

Direct indexing is an investment strategy where an investor tracks the performance of a specific index with two goals in mind:

• Track the return of the index.
• Generate “tax alpha.”

This is achieved by owning a basket of stocks to represent the index, instead of purchasing a mutual fund or Exchange Traded Fund (ETF) tracking that same index. Technology allows the strategy to generate a “tax alpha” by continuously harvesting losses in the account.

Why utilize a Direct Indexing strategy?

• Tax-efficiency

  • This strategy sells individual stocks at a capital loss to offset capital gains (tax-loss harvesting) while maintaining exposure to the selected index. In this way, the performance mirrors the index, but the strategy accumulates losses to offset capital gains. Under current tax legislation, capital losses can offset capital gains not to exceed a net loss position of $3,000. Investors can carry forward any remaining losses indefinitely!

• Portfolio customization

  • An investor can tailor the basket of underlying stocks to meet specific needs, such as:
    • Environmental, Social and Governance (ESG) preferences that may:
      • Exclude industries (i.e., tobacco, fossil fuels, etc.), and/or
      • Include an overweight to sectors with a particular focus (i.e., green energy, vehicle electrification, etc.).
    • Human Capital preferences may consider an investor’s profession as a “holding” in their portfolio. This could warrant the exclusion of a specific sector or stock to avoid an overweight.
    • Assessing Concentrated Positions where an investor may need to:
      • Prohibit future purchases, and/or
      • Chip away at the current position by gradually utilizing the capital losses generated by the strategy to offset material unrealized capital gains.

Who should invest?

This strategy is most appropriate for investors in high tax brackets (e.g., 32%+), where the “tax alpha” has a greater probability of exceeding the underlying cost of the strategy.

How to access a Direct Indexing product?

Until recently, financial institutions only offered Direct Indexing to ultra-high-net-worth investors. However, with the introduction of $0 trading commission, institutions with this technology can implement the strategy cost-effectively making it more available.

How much does it cost?

The internal expenses may range between 0.30% to 0.50%, which is high compared to the average passive fund, around 0.13%. However, it is less expensive than the average actively managed fund, north of 0.60%.

Be sure to pursue this product with an advisor or institution that does not charge trading fees as the turnover is high. US-based equities typically don’t incur a fee, but this is not always the case with international equities (ADRs).

What impact will Direct Indexing have on mutual funds and ETFs?

It’s too soon to tell! However, various asset managers, including Blackrock, Fidelity, Vanguard, and Schwab, either recently acquired direct indexing technology providers or announced the development of their own direct indexing solution.

Whether you gain access to Direct Indexing on your own or through your advisor, this product should be utilized in conjunction with strategic tax planning. With asset minimums decreasing, we view this as becoming more of a “core” part of our clients’ portfolios, given current tax legislation. Want to learn more? Contact us today! As always, please consult your tax advisor for tax advice.