Today’s high-net-worth (HNW) investors have access to tools that allow for unparalleled portfolio customization. Among these, direct indexing stands out as a powerful solution for maximizing outcomes.
How does it work?
Traditional mutual funds and ETFs are excellent tools for many investors. However, these pooled investment vehicles treat all investors the same, regardless of their unique circumstances. Direct indexing changes the game by allowing investors to own individual stocks in a separately managed account (SMA). These accounts replicate the performance of traditional funds or ETFs while enabling a more personalized approach tailored to the investor’s needs.
The Benefits of Direct Indexing
Tax Efficiency:Direct indexing allows for tax-loss harvesting (TLH) at the individual stock level, rather than at the fund level. This finer level of control captures additional tax benefits, particularly when paired with daily scans for opportunities. It also enables more precise identification of stocks for charitable giving, further enhancing tax efficiency.
Customization:Investors can tailor portfolios to their unique preferences, such as:
Tilting toward specific stock characteristics.
Incorporating Environmental, Social, and Governance (ESG) or Socially Responsible Investing (SRI) principles.
Avoiding certain sectors or companies to reduce career overlap risk or align with personal values.
Transparency:Direct indexing provides full visibility into the portfolio, enabling strategic planning around concentrated positions and minimizing tax impacts from large holdings.
Tax Efficiency: Direct indexing opens avenues for tax-loss harvesting (TLH) at the individual security level as opposed to the fund or ETF level, capturing additional tax benefits. This strategy, especially with daily scans, maximizes tax alpha. It can even allow for more precision in identifying potential charitable gifting opportunities.
Customization: Investors gain control, tailoring portfolios to individual preferences and needs. This includes tilting portfolios toward specific stock characteristics, incorporating ESG investing, or eliminating specific names or sectors based on career overlap risk or company policies.
Transparency: Knowing the exact portfolio contents allows for strategic construction around concentrated positions, minimizing the tax impact.
A Long-Standing Strategy with New Accessibility
While ultra-high-net-worth investors have leveraged SMAs for decades, advancements in technology have made direct indexing accessible to a broader HNW audience. Innovations like automation, commission-free trading, and fractional shares now allow more investors to benefit from this customized approach.
Is this a new strategy?
While ultra-high-net-worth investors have utilized SMAs for years, recent technology developments have made personalized indexing accessible to a broader HNW audience. Automation, commission-free trades, and fractional shares contribute to this accessibility.
The Power of Tax-Loss Harvesting
One of the most significant advantages of direct indexing is the ability to harvest losses at the individual security level.
How It Works: Stocks falling below their cost basis are sold and strategically replaced to avoid wash-sale rule violations. This allows investors to capture losses even in rising markets, maximizing after-tax returns.
Frequency Matters: Frequent TLH scans, especially daily evaluations, significantly enhance after-tax returns. For HNW investors in higher tax brackets, personalized indexing with daily TLH scans can boost after-tax returns by 1%–2% or more annually.*
The Challenge of Tax Alpha Decay
Over time, systematically harvesting tax losses can deplete the portfolio of losing stocks—a phenomenon known as tax alpha decay. Maintaining effectiveness may require:
A broadly diversified portfolio with ample opportunities for ongoing tax-loss harvesting.
Adding new cash flow to refresh the portfolio’s harvesting potential.
Enhanced Customization Options
For investors with ESG or SRI preferences, direct indexing enables precise alignment with values:
Screens: Exclude companies or sectors misaligned with specific values.
Tilts: Emphasize investments in areas that meet defined criteria.
Exclusions: Avoid companies or sectors that pose risks, such as career overlap or policy concerns.
Is Direct Indexing Right for You?
Direct indexing is not a one-size-fits-all solution, but it can be a powerful tool for investors with the right circumstances. Consider it if:
You’re in a higher tax bracket with taxable accounts and can benefit from robust tax-loss harvesting.
You have ESG or SRI convictions requiring detailed portfolio customization.
You’re comfortable modifying risk exposure by incorporating factors like value, size, and profitability.
You have embedded capital gains and need a tax-efficient transition plan to diversify a portfolio with large individual stock holdings.
Conclusion
Direct indexing is a highly effective strategy for creating tailored, tax-efficient portfolios, particularly for HNW investors. When paired with a comprehensive financial plan, it offers a unique opportunity to align investments with personal goals, values, and tax considerations.
If you’d like to learn more about how direct indexing can work for your portfolio, contact Altruist Planning today.
Disclaimer: This content is for informational purposes only and is not intended as personalized financial, tax, or investment advice. While we strive to provide accurate and up-to-date information, all investments carry risk, and past performance is not indicative of future results. Any strategies or insights discussed may not be suitable for your specific situation. If you’d like to discuss how this applies to your financial plan, feel free to reach out.