Consider Direct Indexing for Tax-Management & Values

By Daniel Flannery, CFA and Brian Doherty

Introduction to Direct Indexing

Index funds that successfully capture the total returns of the market have been one of the great financial innovations of the last several decades, delivering market returns at a low cost for all investors. What if you were able to capture the same index returns, but with the opportunity for additional tax benefits and the ability to customize your holdings to reflect your values? Enter Direct Indexing.

What is Direct Indexing?

Direct indexing is a primarily passive investment strategy in which an index (typically an entire market) of investments is replicated through the ownership of the individual companies that make up that particular index. Instead of index Mutual Fund or Exchange Traded Fund (ETF) ownership where investors own shares of a basket of securities that seeks to track a benchmark (i.e. S&P 500) by owning all of the constituents, with a direct indexing strategy an investor can directly own a sample of the individual stocks that make up the benchmark (target) index. It is not necessary to own every company that makes up the benchmark index to create a statistically equivalent portfolio, and the strategy can work with as few as 50 – 300 individual stocks.

Why Now?

With the arrival of commission-free stock trading for most securities the cost of trading numerous stock positions is no longer a barrier to direct indexing, making it accessible to accounts of roughly $100,000 and more, where it previously only made sense for much larger accounts. New and improved statistical analysis and trading programs that firms such as Balanced Rock use allow us to better replicate the risk and return of an index across numerous factors and build a similar portfolio from individual securities. The result is that we are now able to both effectively and efficiently implement this customized strategy for many clients.

While tracking tax cost-basis was historically entirely the taxpayer’s responsibility, brokers are now required to track the cost basis of all positions and maintain that information, and pass it along to future brokers when transfers take place. This removes much of the tax reporting complexity of owning, buying and selling so many positions.

Benefits of Direct Indexing

So, what does this mean for you? Below we describe the three greatest benefits that we see from a direct indexing strategy. 

Increased Tax-Loss Harvesting Opportunities

Direct indexing allows investors to harvest losses at the company level which opens up a significantly greater number of opportunities. As Vanguard points out, “the value of the S&P 500 increased 11.7% in the fourth quarter of 2023, yet there were still 178 individual companies that lost value during that time”1. This means that investors who leveraged a direct indexing strategy would still be able to harvest losses from the individual decliners while also participating in the market’s gain. The harvested losses can then be used to offset current or future capital gains or up to $3K of ordinary taxable income per year.

According to the same Vanguard article, the average 10-year increase in after-tax returns as a result of direct indexing with quarterly tax-loss harvesting was more than 1% annually for a high-net-worth individual and 1.8% annually for an ultra-high-net worth investor.2 Producing tax alpha (which means increasing after-tax returns by saving or deferring taxes) is a valuable part of the work we do for our clients. We think that for many clients a direct indexing strategy can increase the amount of tax alpha we can generate for them whether the market is up or down.

Greater Values Customization

While the availability mutual funds and ETFs incorporating values screens has greatly increased over the past few years, these funds are far from personalized. The values spectrum for investors is quite broad. What is important to one investor may not matter to another investor. Because of this broad range of values and the standardized nature of values-oriented funds, the funds cannot adequately personalize or satisfy all investors simultaneously. With direct indexing, investors have greater ability to pick and choose the combination of values screens that satisfy their personal preferences. For example, in addition to screening based on business practices or involvement, it is possible to exclude entire industries (i.e. fossil fuel industries) or an entire geographical region or country (i.e. authoritarian governments such as China) using a direct indexing strategy.

Reduced Expense Ratio Drag

By owning the individual companies that make up an index as opposed to a mutual fund or ETF that tracks the index, investors save on the fund management fee expenses that are incurred by the funds.

Risks to Consider

While there are potential benefits, there are also risks to consider when deciding whether or how to implement a direct indexing strategy.

Tracking error

Tracking error is the standard deviation of the difference between the returns of the targeted index and a portfolio. It indicates how close the portfolio performance is to the performance of benchmark index.3 While expected tracking error can be calculated beforehand, the actual tracking error experienced by a portfolio will vary. Over time, the tracking error can increase, decrease, or have no impact on actual portfolio returns compared to the benchmark. To avoid variation from index returns, an investor can use index funds instead which typically hold all or most of the securities in an index, greatly reducing tracking error.

Tax complexity and wash-sale management

As a result of owning more securities in a direct indexing strategy compared to a more typical strategy invested in mutual funds or engaged in an active security selection, there are more opportunities for tax-loss harvesting and with that greater potential for wash sales if the strategy is not implemented properly. Similarly, controls need to be put in place in order to avoid short term gains if desired.

Increased transaction costs from additional trading

Depending on your pricing structure for trading, this strategy may increase your transaction costs. This should be carefully considered when deciding whether to implement the direct indexing strategy, particularly where there are per trade commission expenses.

No tax benefits in Roth or Traditional IRAs or tax-deferred accounts

It is important to note that the potential tax-benefits of a direct indexing strategy, which come from the increased tax-loss harvesting opportunities provided when compared to a fund-based investing strategy, are only available to investors using taxable accounts (such as individual or joint brokerage accounts, or trusts) to implement the strategy. Using the direct index strategy in a Roth or Traditional IRA or in any tax-deferred account will not result in additional tax benefits.

Next Steps

If you are interested in learning how a direct indexing strategy could be employed in your investment account, please set up a time to speak with your Balanced Rock advisor or sign up for a free introductory meeting here if you don't work with us yet.

Sources

1.       The Vanguard Group, “What is direct indexing?", January 10, 2024: https://advisors.vanguard.com/insights/article/what-is-direct-indexing?cmpgn=FAS:PS:XX:PERSONINDEX:20231005:GG:DM:WhatisDirectIndexing:NOTARG:NONE:XX:XX&gad_source=1&gclid=Cj0KCQiAwP6sBhDAARIsAPfK_wZa4Yfe2g7ireC5NVOTgaB7o0LdgD8hJe0DYDjhmrluO-1z4MMRsrQaAlY_EALw_wcB&gclsrc=aw.ds

2.       The Vanguard Group, “What is direct indexing?", January 10, 2024

3.       Tracking error, https://en.wikipedia.org/wiki/Tracking_error