What is Direct Indexing and How Does It Work
Direct indexing is a relatively new investment strategy that has risen to prominence over the last decade. Previously, this strategy was cost-prohibitive for many investors due to commission-based trading. However, with the rise of no-commission trades, direct indexing is now much more widely available to the everyday investor.
At its most basic level, direct indexing involves purchasing a bundle of stocks to match a specified index such as the S&P 500 or NASDAQ. This is distinctly different from an ETF that matches an index because, with an ETF, you do not actually own the underlying shares. An ETF takes a passive approach to tracking an index, which is managed by various asset manager.
Because you own the underlying shares of the index, this allows the asset manager of the direct indexing strategy to actively trade the shares you own. This is often done to generate capital losses that can then be offset against your taxes. With an indexed ETF, you won’t be able to generate those capital losses unless you sell the ETF itself and then wait out the 30-day wash sale rule.
Who is Direct Indexing For?
Due to the significant tax advantages of direct indexing, it may be no surprise that investors with high taxable incomes or high tax burdens are often the best fit for direct indexing strategies. The capital losses generated can greatly reduce the taxes owed by an investor. Generally direct indexing strategy will be able to show, in percentage terms, what their tax savings are for a given year so you can weigh if the costs of the strategy offset your taxable income to a greater extent.
Another group of investors that direct indexing may appeal to are those holding stocks with significant unrealized capital gains. The ability to generate capital losses efficiently may allow the investor to diversify their concentrated or highly appreciated position over time as the losses are generated.
Pros & Cons
Here are a few pros and cons to consider when thinking about direct indexing.
Pros
- Tax Efficiency: The ability to generate capital losses to offset taxes during times of market volatility is one of the primary reasons investors favor direct indexing strategies.
- Customization: Just because you’re tracking a specific index doesn’t mean you can’t customize your portfolio to your liking. You can adjust risk tolerance or even skew your preferences towards cause-based investing like ESG.
- Control: Direct indexing gives you direct control over your portfolio by owning the underlying shares rather than relying on an ETF.
Cons
- Cost: Direct indexing strategies can be quite expensive depending on the asset manager, with fees often exceeding 1%. This is due to the difficulty of tracking an index and the frequency of trades.
- Tracking Error: No strategy is perfect, and this is also the case with direct indexing. Many portfolios have some tracking error, which may lead to underperformance.
- Capital Required: Due to the large basket of securities you’ll likely need to hold, direct indexing can require significant upfront capital to get started.
If you feel like direct indexing could help your current financial situation, consult with your financial advisor to see how this tax advantageous strategy may work with your current financial plan and goals.
Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Past performance is not a guarantee of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification.
While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
Investments that utilize a direct indexing strategy carry specific risks that investors should consider before investing. In certain market conditions, passive direct indexing investment strategies may lose value or underperform active strategies. Direct indexing strategies have the risk of not closely tracking the performance of the underlying index they seek to replicate. While attempting to track an index, passive investments often do not consider a company's profitability, financial health, or growth potential in their investment selection criteria.
Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. Prospective investors should consult with their tax or legal advisor prior to engaging in any tax-loss harvesting strategy.
Investors should consider the investment objectives, risks, charges and expenses of an exchange traded fund carefully before investing. The prospectus contains this and other information and should be read carefully before investing. The prospectus is available from your investment professional.