Direct indexing as an investment strategy 

Customized products and experiences are popular these days. Even in the case of stock investments, it’s now possible for investors to “customize” and personalize their own stock portfolios. This is known as direct indexing. 

Direct indexing is the slightly more complex version of a mutual fund, index fund, or Exchange-Traded Fund (ETF). Direct indexing has benefits that are not present in the other kinds of funds. One of the benefits is that investors enjoy a lot more flexibility in choosing or managing the individual stocks in their portfolios with direct indexing.  

In this article, know more about direct indexing and answers to questions like is direct indexing worth it, the benefits of direct indexing, direct indexing costs and other important insights.  

Introduction to direct indexing 

Direct indexing is an investment strategy that was formerly reserved for more affluent investors. In the past, only those who had at least $1 million to invest could adopt this strategy, since direct indexing meant paying a lot in commissions and fees. Typically, this also meant buying the stocks in the same weights, so imagine the cost!  

But now, thanks to online brokerage platforms (and many RIA custodians) that offer zero-commission trading, investors don’t have to be millionaires to do direct indexing. Investors with as little as $5,000 can mimic indexes like the S&P500 or the Russell 2000 via direct indexing.  

How direct indexing works 

Investors direct their financial advisors or investment managers to buy stocks that mirror an index (or multiple indices) that they choose, via separately managed accounts or SMAs. And instead of attempting to match the performance of a stock index by purchasing mutual funds or ETFs, investors only buy a small part of individual stocks to imitate the index.  

Since investors buy individual shares, they now have the option of customizing their portfolios to not include stocks of companies that aren’t compatible with their views or financial goals.  

What are the pros and cons of direct indexing?  

Investors choose this investment strategy because it can be advantageous. Here are some of the benefits of direct indexing:  

The pros of direct indexing 

1. Allows for customized portfolios 

This is the main benefit of direct indexing. Investors have much more control over their stock portfolios as they can choose which individual stocks go into them. They can choose stocks that align with their financial goals and preferences.  

Jack Bogle, the renowned “father of mutual funds” made it easier for investors and advisors to cobble together stocks in mutual funds. So why bother with direct indexing? Simply for the benefits of ESG investing, the high degree of customizing portfolios, and reducing portfolio risk. Watch the video to know more.  

2. Affords greater tax efficiency and tax savings 

Direct indexing allows investors to control when and how they realize their capital gains from trading. Investors can potentially shrink their tax liabilities at the end of the fiscal year by harvesting tax losses to offset any gains. Investors can also put off realizing the gains and wait for a more favorable tax year.  

3. Makes ESG investing easier 

Since investors have greater control over their stock portfolios with direct indexing, they can choose to include or exclude individual stocks.  

Compared to mutual funds and ETFs, direct indexing allows investors to exclude stocks that don’t align with their values. This can be a good way for investors to build an ethical investment portfolio. So, for instance, they can remove or avoid individual securities in tobacco companies, weapons manufacturers, and companies that have been flagged for environmental degradation or human rights abuses. 

4. Improved risk management 

Another significant benefit of direct indexing is better risk management. Since direct indexing means owning individual stocks, your clients can easily diversify their portfolio. Doing so potentially reduces their exposure to specific risks of a particular sector or company.  

With direct indexing, advisors can also customize clients’ portfolios based on clients’ individual risk tolerance and investment goals, affording them more control over their investments. 

5. More beneficial charitable giving 

Giving money to charities with a direct-indexed portfolio is not only easier but can give a tax break to the investor. They can even give stock instead of money, then pay the appropriate taxes. Investors can contribute to causes that reflect their values, while potentially paying less taxes on them.   

On the other hand, investors should also know the risks and drawbacks of investing via direct indexing. Apart from some confusion about the name itself, direct indexing is not without its flaws. 

The cons of direct indexing 

1. No benefits for retirement accounts 

One drawback to direct indexing is that the losses cannot be deducted from 401(k) plans or IRA. The losses cannot be deducted from these tax-deferred accounts. However, retirement accounts still benefit by being able to implement various “screens” – including ESG.

2. It’s subject to the “wash sale rule”  

The wash sale rule states that investors who sell stocks at a loss then buy the same or another very identical security within 30 days before or after the sale cannot declare a loss for that stock in their tax return for that year. However, most established Direct Index providers have systems in place to avoid these wash sale rules. 

3. There are restrictions to offsetting gains 

Long-term losses on investments held for more than a year can only be offset by long-term gains. The same applies to short-term losses; only short-term gains can offset them. Should investors have excess losses in one category of investments, then these can be applied to the gains of either type.  

4. The initial minimum investment can be high 

In the past, investors would need to have at least $1 million to employ a direct indexing strategy. But these days, it’s possible to do direct index investing with way less money than that, but the requirement is still significant. Some direct index investing services can still be as high as $100,000 to $200,000. At least one financial institution, Fidelity, offers direct indexing portfolios for as little as $5,000.  

Here’s a list of some direct index portfolio products from popular investment firms:  

What is tax loss harvesting in direct indexing? 

Tax loss harvesting refers to the process of selling a security at a loss, so you or your client can potentially use the losses to offset other capital gains.  

Investors who don’t have any capital gains can use up to $3,000 of those losses to offset their ordinary income taxes. This means paying less taxes either way.  

They can then reinvest the proceeds in a similar (but not identical) investment, so the portfolio is allocated as intended without violating the wash sale rule.  

Tax loss harvesting also allows investors to carry any unused tax losses forward and offset future capital gains. 

Who should consider direct indexing?  

Looking at the pros, cons, and opportunities that direct indexing presents, is it an investment strategy worth adopting, especially for beginning investors? Here are some scenarios where investors are more likely to benefit from direct indexing:  

1. Investors in a higher tax bracket 

Investors with high income can largely benefit from harvesting losses. This can effectively shield more of an investor’s money from more taxes. Remember, investors in the highest capital gains tax bracket must pay at most up to 23.8% (the 20% long-term capital gains rate, plus the 3.8% Net Investment Income Tax) on their long-term gains.  

Meanwhile, short-term capital gains can be taxed as high as the 40.8% income tax rate (the 37% short-term capital gains rate, plus the 3.8% Net Investment Income Tax). If your client is at this tax bracket, any opportunity to shrink taxable gains is certainly welcome. 

2. Investors with stocks in taxable accounts, but with a longer timeframe 

Having a lot of time invested in the equity markets gives investors more compounded growth. The compounding applies to the added returns investors keep when they harvest losses. Regularly harvesting losses from a direct index can boost the after-tax returns, compared to the returns from traditional indexes. 

3. Investors who have a concentrated stock position that has substantial gains 

Investors with a large amount of stock in one or a few companies can reduce their risk with direct-indexing strategies. This means selling some of their concentrated stock positions to offset tax liabilities and customizing their portfolio to exclude high-risk stocks.  

For example, if an investor has $3 million in a single technology company’s stock, they can move their assets into a broad stock market index to lower your risk. With direct indexing, they can gradually sell off some of the stock over time while also offsetting gains with losses from direct-indexing portfolio. 

4. Investors who regularly contribute to charity 

Owners of stocks in direct-indexing portfolios enjoy more flexibility when it comes to supporting the causes they believe in. Donating highly appreciated stock that they’ve held for more than a year (instead of selling it and donating the money) can increase the value of the gift for both investor and beneficiary. 

Donating the stock directly helps avoid paying capital gains tax, potentially increasing the amount available for the charity by up to 23.8%. What’s more, investors can claim the fair market value of the stock as a deduction on taxes for the year of the donation.  

For stock held for less than a year, only the purchase price can be deducted, not the appreciated value. The tax deduction only applies if it’s itemized on the tax return, and there’s a limit of 30% of adjusted gross income for donating appreciated assets. 

Beginning investors are fortunate that they can venture into this investment strategy, since the cost of entry is no longer as high as it used to be. While direct indexing can be a favorable investment strategy with tax benefits, it’s not for everyone. Investors should first consider other factors like their risk appetite, financial goals, and time horizon before using this strategy for their stock portfolio.  

Go over our collection of articles on direct indexing for more tips and best practice on this investment strategy.