Direct Indexing: What it is, How it Works, and its Benefits
Many investors are familiar with mutual funds and exchange-traded funds (ETFs), which allow them to invest in a preselected “basket” of stocks, often to follow an existing market index. However, fewer are aware of an approach called direct indexing, which also seeks to replicate an index’s performance but can offer greater tax efficiency and opportunities for individual customization.
Founder and CEO of Archipelago Wealth Management, Arthur Muñiz, CFP®, CEPA® , AIF® shares his insights:
Read on to learn what direct indexing is, how it works, and if it is right for you.
What Is Direct Indexing?
Put simply, direct indexing is a method of investing in which investors buy individual stocks that make up an index, in the same weights as the index. This approach allows investors to customize their portfolios according to personal preferences or specific investment strategies.
Unlike index mutual funds or ETFs that bundle stocks into a single investment, direct indexing offers greater control over which stocks to own and when to adjust holdings as index compositions change.
Take it from Arthur Muñiz,“For investors with non-retirement funds who invest in index mutual funds and ETFs, there is a more tax efficient solution: direct indexing… it includes this tax strategy which has the potential to add tax alpha to their performance.”
How Does Direct Indexing Work?
Direct indexing is a method that aims to replicate an existing stock index, like the S&P 500 or the Russell 3000, within a taxable account. This approach involves using a separately managed account where an investment manager directly owns individual stocks that make up the chosen index. By using optimization software, the manager includes a sample of the index’s stocks, closely mirroring its performance.
Why not just invest in a mutual fund or ETF that tracks your chosen index? Direct indexing offers potential tax savings that index-tracking funds typically don’t. Additionally, it provides more flexibility in choosing which individual stocks to own. Let’s take a closer look at these benefits.
Benefits of Direct Indexing
Helping Reduce the Impact of Taxes
One of the biggest potential benefits of direct indexing is the ability to use a strategy called tax-loss harvesting. This involves selling positions that are down—“harvesting” or recognizing the losses—and using those losses to offset capital gains from other positions, including those from other asset classes or managers. This strategy may help lower your tax bill. Some direct indexing platforms may offer automated solutions to opportunistically harvest tax losses throughout the year.
Tax-loss harvesting typically isn’t an option with an index-tracking fund because you own interests in the fund, rather than the individual securities.
Investing for Your Goals and Values
Another potential benefit of direct indexing that you won’t find with a typical index fund is the ability to customize your portfolio’s holdings. Index ETFs are essentially a package deal—you get every stock that’s part of the index. But with direct indexing, you can tailor your holdings to align more closely with your financial goals or personal values.
For example, if you’re an environmentally conscious investor, direct indexing may allow you to avoid certain companies with high carbon emissions. Or, if you feel you have too much exposure to a certain stock or sector that you view as risky, direct indexing can help you diversify around that position to mitigate the risk.
You can make adjustments as you see fit with help from a Financial Advisor who will monitor, periodically update, and rebalance your investments so they don’t stray far from performance targets.
Is Direct Indexing Right for You? Here Are Three Questions to Consider
1. Do You Want to Customize Your Holdings?
Index funds and ETFs aim to mirror the returns of a specific index while keeping costs low. However, they offer little flexibility for investors who want to personalize their holdings. Direct indexing addresses this by allowing investors to exclude or substitute individual stocks within an index, similar to choosing toppings on a pizza. This customization is managed through a separately managed account, offering opportunities to align investments with personal values or strategic goals.
2. Would You Prefer to Match or Outperform the Market?
For many investors, matching the market’s performance is sufficient. Direct indexing focuses on enhancing after-tax returns through tax-loss harvesting, a strategy unavailable in traditional index funds or ETFs. By strategically selling underperforming securities to offset gains, direct indexing aims to provide tax advantages that can accumulate significantly over time, potentially outperforming a buy-and-hold strategy.
3. Are Emotions a Concern in Your Investment Decisions?
Emotions often influence investment decisions. While index funds and ETFs provide a passive approach, direct indexing blends active management benefits with investor control over initial holdings. Portfolio managers oversee day-to-day operations, including tax-loss harvesting, which can mitigate the impact of emotional trading. This approach combines the advantages of active management with lower costs compared to traditional actively managed funds.
In summary, direct indexing offers a unique investment strategy that appeals to those seeking customization, potential tax benefits, and a balanced approach to managing emotions in investing. Consider consulting with a financial advisor to determine if direct indexing aligns with your financial goals and risk tolerance.
Interested in Learning More?
At Archipelago Wealth Management, we recognize the unique needs and challenges faced by high-net-worth investors. Our team of seasoned financial advisors specializes in crafting personalized investment plans tailored to your aspirations and financial complexities. By partnering with us, you can navigate the intricacies of wealth management and pursue your financial goals with confidence.
Contact our team today to begin your journey toward financial prosperity and strategic wealth management.
