Foundations & Endowments

What are the Tax Benefits of Direct Indexing?

What are the Tax Benefits of Direct Indexing?
March 11, 2024

The Tax Advantages of Direct Indexing for High Net Worth Investors

Direct indexing is an investment strategy that is rapidly gaining popularity among high net worth investors and financial advisors. By directly owning the underlying securities in an index, direct indexing provides greater flexibility, customization, and potential tax advantages compared to investing in mutual funds or ETFs.

One of the biggest benefits of direct indexing is the ability to efficiently harvest tax losses at the individual security level in order to reduce an investor's overall tax liability. This article will explore the key tax advantages of direct indexing and why it appeals to high net worth investors.

What is Direct Indexing?

Direct indexing aims to closely track the performance of a benchmark index like the S&P 500 by owning the underlying securities directly. Rather than investing in a mutual fund or ETF that tracks an index, a direct indexing portfolio holds the actual stocks, bonds or other assets.

A direct indexing portfolio typically owns a representative sample of the securities in the benchmark index. Advanced software and algorithms are used to optimize the portfolio to target index-like returns while providing opportunities for customization and tax management1.

Some key features of direct indexing include:

  • Direct ownership of securities: The investor owns the actual stocks or bonds rather than owning shares of a fund.
  • Customization: Portfolios can be tailored based on an investor's preferences, values and tax considerations.
  • Tax management: Taking advantage of tax-loss harvesting at the individual security level can net after-tax returns.

Why Direct Indexing Appeals to High Net Worth Investors

Direct indexing is especially compelling for high net worth investors for several reasons:

1. Tax Reduction Through Loss Harvesting

One of the biggest draws of direct indexing is the ability to efficiently harvest tax losses. By directly owning the underlying securities, losses can be harvested at the individual stock level. This can allow investors to offset realized capital gains from other investments and reduce their overall tax liability2.

Selling losing positions to realize losses is known as tax-loss harvesting. These losses can be used to offset capital gains realized elsewhere in the investor’s portfolio. And because direct indexing portfolios rebalance through buying and selling individual stocks, there are more frequent opportunities to realize losses3.

Software monitors the portfolio on a daily basis and will recommend selling positions that have declined in value. By taking the loss, the investor can use it to offset their tax liability. Automated tax-loss harvesting ensures no opportunities are missed4.

For high net worth investors with significant capital gains from business sales, real estate transactions, or other investments, tax-loss harvesting can meaningfully reduce their tax bills. Direct indexing provides high net worth investors with much more robust tax-loss harvesting capabilities than mutual funds or ETFs5.

2. Transitioning Concentrated Stock Positions

Another benefit of direct indexing for high net worth investors is transitioning out of concentrated single stock positions in a more tax-efficient manner.

Executives often accumulate significant company stock holdings. While selling shares could trigger a large taxable gain, the lack of diversification also presents a risk. Direct indexing allows an investor to systematically diversify away from the concentrated position in a tax-efficient way over time6.

By pairing the stock with a direct indexing portfolio, losses harvested from the portfolio can be used to offset gains as the position is slowly sold off. This “tax-managed transition” strategy allows the position to be diversified while minimizing taxes7.

3. Alignment With Values

Direct indexing also appeals to high net worth investors because it allows fine-tuning of the portfolio to align with their environmental, social and governance (ESG) values8.

Unlike mutual funds and ETFs where the investor owns a pre-packaged basket of securities, direct indexing allows exclusion of certain sectors, industries or specific stocks that the investor wishes not to own. This flexibility allows investors to build values-based portfolios.

The ability to completely customize and control the underlying holdings makes direct indexing very attractive to high net worth investors who want their investments closely aligned with their beliefs and preferences.

Implementing a Direct Indexing Strategy

While direct indexing offers compelling advantages, it also comes with greater complexity both in implementation and in maintaining the portfolio. As such, most individual investors work with financial advisors to develop and manage direct indexing portfolios.

Here is an overview of implementing a direct indexing strategy:

1. Determine Appropriate Accounts

Because direct indexing is tax-driven, it generally makes the most sense for taxable investment accounts. Retirement accounts do not benefit from tax-loss harvesting. High net worth investors can use direct indexing for taxable accounts while using mutual funds or ETFs for IRAs and other tax-advantaged accounts.

2. Choose a Benchmark Index

Work with your advisor to determine an appropriate benchmark index that aligns with your risk tolerance and asset allocation needs, such as the S&P 500, a total US stock market index, or a total world stock index. The portfolio will be optimized to closely track the benchmark.

3. Build and Customize the Portfolio

The advisor will use portfolio modeling tools to establish a representative sample of securities from the benchmark index. This subset of stocks and bonds allows the portfolio to match the risk and return characteristics of the chosen index.

The advisor can then customize the portfolio based on the investor's preferences to exclude certain sectors, industries, or specific stocks. Values-based customization and restriction screens can be applied based on ESG criteria.

4. Implement Tax-Loss Harvesting

Tax-loss harvesting strategies will be established to efficiently realize portfolio losses to offset capital gains. Software monitors the portfolio, and the advisor oversees trading to ensure losses are efficiently harvested while maintaining proper portfolio optimization.

5. Rebalance Through Disciplined Trading

Because the portfolio only owns a subset of the full index, drift will occur over time. Disciplined rebalancing trades are required to keep the portfolio optimized to the benchmark. By following a prescribed rebalancing methodology, advisors can maintain full exposure to the index.

The advisor handles all of the complex portfolio management processes involved in direct indexing like monitoring, rebalancing, loss-harvesting, and customization. This allows the investor to benefit from the advantages of direct indexing while outsourcing the day-to-day management.

Conclusion: A Tax-Efficient Strategy for High Net Worth Investors

With increasing demand for customization and tax efficiency, direct indexing presents an appealing option for high net worth investors. Directly owning securities provides greater loss-harvesting potential compared to funds, allowing investors to minimize their tax bills.

Direct indexing also helps facilitate transitions out of concentrated stock positions and builds portfolios aligned with investor values. As the technology and availability of direct indexing solutions continue improving, adoption rates will likely continue rising among wealthy investors and their financial advisors.