Direct Indexing: Pros, Cons, and Strategies
What is Direct Indexing?
Direct indexing is an investment strategy where investors replicate a specific market index by directly purchasing the individual stocks that make up the index, rather than investing through an index fund or exchange-traded fund (ETF). Instead of holding a single security that mirrors the performance of the index (like an ETF), investors own the underlying components of the index directly in their portfolio.
For example, an investor might own a fund that tracks the S&P 500 such as VOO or SPY. They own a single fund that pools their money with other investors to buy the largest 500 companies in the United States. As the underlying 500 companies move in price, the investor in the funds receives the average return of all of the underlying positions.
This can be an excellent way to invest and grow money but it has a limitation – you cannot make a transaction on the underlying positions which limits your ability to coordinate other strategies like tax loss harvesting certain underlying positions, donating highly appreciated positions, or excluding positions from the portfolio due to concentration elsewhere.
Enter Direct Indexing.
fractional shares, wash sale rule, zero cost trading on stocks
How It Works
Direct Indexing is simply an account – what’s called a separately managed account or SMA – that goes out and buys the underlying stocks directly. It utilizes fractional investing in order to maintain appropriate exposure to the underlying stock mix based on the index it is attempting to mimic.
For example, if you invest $100,000 in a direct indexing portfolio tracking the S&P 500, you will mostly own 500 individual positions in the account and some of the stocks may be less than 1 shares.
I say mostly own because some positions might be too small to warrant an allocation depending on the index. However, your overall exposure to the index will be very similar.
Common Tracked Indices
Direct indexing can track different indices but the most common are:
- S&P 500
- Nasdaq 100
- Russell 2000
- Russell 1000
Benefits
Tax Loss Harvesting
Individual securities in the portfolio are monitored for opportunities to harvest losses by selling underperforming stocks and replacing them with similar ones to maintain the index exposure.
There are several benefits to tax loss harvesting:
- Losses can offset gains elsewhere in the portfolio.
- If your losses exceed your gains, you can deduct that against your regular income up to $3,000 per year.
- Losses can carry forward indefinitely.
With a direct indexing portfolio, you can also experience a unique situation where you are recognizing taxable losses while your portfolio still gains in value!
While actual results vary based on market conditions, it’s possible to be able to recognize about 15-30% of the initial portfolio as taxable losses over a 5 year timeframe.
Excluding Concentrated Positions
One benefit to direct indexing is customization. An investor can specify, within limits, different positions they want to limit.
For example, let’s say they are an executive of a publicly traded company like Microsoft who owns significant shares in that company.
If they purchase the S&P 500 or Nasdaq 100, a sizable portion of the investment own Microsoft Stock which adds to their concentration risk.
A direct indexed portfolio can track the S&P 500 but exclude Microsoft stock from it. So it in effect becomes and S&P 499!
Considerations
Fees
When you buy an index fund like VOO or SPY, you pay an expense ratio. With funds of major indexes like the S&P 500, the fee is fairly small such as .03% per year.
With direct indexing, you normally don’t have a fee from the positions themselves but the account will have an annual fee. For example, the account might charge .25% or .35% per year.
These fees are often higher due to the added complexity and decentralized tracking of each index for the investor.
Minimum Account Size
Unfortunately, direct indexing accounts often come with fairly large minimum account sizes such as $100,000 or $250,000. This can make it difficult to access for many people while maintaining proper diversification.
Tax Loss Harvesting Decay, & Capital Gains Accumulation
When you place money into a direct indexing account, the total amount of taxable losses able to be culled out of the portfolio is generally around 15-30% over a 5 year period. However, over time, the ability to generate losses on that new money diminishes and you receive less and less.
This can result in a portfolio with larger embedded capital gains which may have tax implications when attempting to access the funds for use or rebalancing.
Portfolio Composition Over Time
Over time, without a proper long-term strategy, you may find yourself owning a very irregular, and perhaps more risky portfolio than intended.
This is difficult to correct without incurring taxable income from selling positions.
Tracking Error and Index Replication
Due to index construction limitations, it is also possible to deviate from an indexes total return as the underlying weights of your portfolio might deviate from the underlying benchmark.
This could work in your favor or work against you.
Gameplanning
When entering a direct indexing strategy, you should consider the long term impact of the strategy and what you can do to mitigate the impact of the previously discussed items.
Capital Gains Bracket Opportunities
The federal long-term capital gains rate under current tax brackets is 0% up to $98,900 for a married filing jointly couple which means you can recognize a lot of gains every year without taxation assuming your income is able to be low in other areas.
This can present opportunities for getting out of large gain positions with relatively low taxation.
Offsetting Large Upcoming Gains
Accumulating taxable losses can be a great way to offset capital gains from a future event such as a business liquidity event. Beginning tax loss harvesting multiple years ahead can allow you to accumulate a loss carryforward that could offset gains in the 20%+ capital gains levels.
Charitable Donations
Charitable donations can pair beautifully with a direct indexing account as you can take taxable losses from a portfolio, experience the appreciation of the underlying assets, and then donate the biggest winners to fund charitable causes for an even bigger tax deduction.
See Donating Appreciated Stocks to Charities – Gilbert Wealth
Regular Contributions
Rather than funding the direct indexing fund once, making regular contributions to the account can help to maintain a balanced portfolio and provide new sources of tax losses over time. Regular funding helps to reduce tracking errors as well as new funds can fill in the allocation holes.