In the past, commissions and fees made direct indexing expensive and cumbersome. A direct indexing strategy or buying the individual stocks that make up an index, at the same weights as the index was not practical. Now that zero-commission stock trading is an option on many online brokerage platforms and technology has advanced, investors are asking, What is direct indexing? What are the risks and benefits of this investment strategy when compared to mutual funds and exchange-traded funds (ETFs), where many investors pool their money to invest in a basket of securities?
What is direct indexing?
Direct indexing is an investment strategy in which an investor buys the individual stocks that make up an index, such as the Russell 3000 or S&P 500, or a representative sample. Direct indexing attempts to mimic the performance of an index by selecting a representative sample of stocks within the index. In the past, this strategy was only available to institutions and the wealthy. Commissions and the cost of owning multiple shares put it out of the reach of most investors.
By purchasing individual stocks, an investment professional can customize your portfolio by choosing or excluding specific stocks based on their performance, your preferences, and your financial goals. These stocks will mirror the index you choose but will be managed in a separately managed account (SMA).
Direct indexing also enables you to customize your portfolio to reflect your interests and values. This is not the case with ETFs, where your purchase reflects every stock that is part of the index.
Tax efficiency
Investors can reduce their overall capital gains tax burden by selling stocks that have declined in value to offset capital gains from other investments. This process is called tax-loss harvesting and is only available when you own individual stocks.
Individual stocks in an index fluctuate over time. Tax harvesting involves selling stocks that are losing money, recognizing the financial loss, and using it to offset capital gains or taxes on ordinary income, even in investments held in different accounts or asset classes. This tax-saving strategy is not an option with an index-tracked fund because you own interests in the fund, not the individual securities.
Using tax-loss harvesting, if your losses exceed your gains, you can potentially offset up to $3,000 ($1,500 if married filing separately) of your ordinary income in a year or carry the loss forward to offset gains in future years.
There are some restrictions on using tax-loss harvesting. According to the wash-sale rule, if you sell a security at a loss and buy the same or substantially identical security within 30 days before or after the sale, you can’t use the loss to offset your capital gains.
Tax-loss harvesting is not helpful in tax-deferred accounts such as a 401K or an IRA because you cannot deduct losses in these accounts.
Risk management
Investors own a wide range of individual stocks using a direct indexing strategy. This means they can better diversify their portfolio and manage risk. For example, investors who own a lot of stock in the company they are employed at can minimize or not buy these same stocks in their direct indexing portfolio.
What are the drawbacks to using a direct indexing strategy?
There are restrictions on what types of losses can be used to offset gains. For example, a long-term loss would first be applied to a long-term gain, just as a short-term loss (held for less than one year) would first be applied to a short-term gain.
An investment strategy that involves buying individual stocks will probably come with higher management fees than investing in a similar ETF. It is important to determine whether the potential tax savings will offset the increase in management costs. A financial advisor can help you answer this question. Choose one that offers fee-only financial planning to be assured that they are not swayed by any potential commissions they may earn when giving advice.
Direct indexing typically requires a higher minimum investment than other options. In the past, a minimum investment of $250,000 was necessary. Zero-commission trading and fractional shares have made it possible to invest $5,000.
How does direct indexing differ from traditional indexing?
With direct indexing, investors pick and choose individual stocks to flesh out their portfolio. They can customize it to meet their goals. With traditional index funds, investors would use a mutual fund or an ETF to track the underlying index. Every investor holds the same set of underlying securities.
If you are an investor who has traditionally invested in index funds and ETFs and wants to have more control over your investments, direct indexing may be a good option. Direct indexing enables investors to go beyond replicating the return on the market or a specific benchmark index without taking on too much additional risk by taking advantage of tax-loss harvesting opportunities. Investors who live in high-income tax states, such as New York and California, have the potential to enjoy even more tax savings.
There is no one-size-fits-all guide to investment. Working with a wealth manager can ensure you make the best financial decisions for yourself and your loved ones.
