Direct indexing is an investment strategy where investors own the underlying securities of an index directly in a separately managed account (SMA), rather than owning shares of an index mutual fund or ETF. The SMA is customized to replicate the performance of a benchmark index like the S&P 500.
With direct indexing, investors have more control and flexibility over their portfolios compared to owning index funds. They can customize their portfolios by excluding certain securities or tilting towards specific factors. Direct indexing also allows for tax-loss harvesting at the individual security level, which can lead to greater tax efficiency.

Benefits of Direct Indexing

Here are some of the key benefits of using a direct indexing strategy:

1. Tax Efficiency Through Tax-Loss Harvesting

One of the biggest advantages of direct indexing is the ability to tax-loss harvest at the individual security level to improve after-tax returns. This involves selling securities trading below their purchase price to realize losses to offset capital gains elsewhere in the portfolio. The losses can also offset up to $3,000 of ordinary income¹.

Studies show that direct indexing portfolios generate an average of 1.08% in additional after-tax returns through tax-loss harvesting². This "tax alpha" can make a meaningful difference for high net worth investors in high tax brackets.

2. Customization and Personalization

With direct indexing, investors can customize their portfolios to align with their financial goals, risk tolerance, and personal values³. For example, they can screen out certain sectors or securities that don't meet their investment criteria.

Direct indexing allows for social responsible investing by avoiding companies with poor ESG practices. It also enables values-based customization, such as restricting tobacco, alcohol or weapons stocks.

3. Control of Underlying Securities

By directly owning the securities, investors have more control over their portfolios. They can choose to overweight specific factors or securities compared to the index based on their preferences⁴.

Direct indexing also allows investors to manage concentrated stock positions. They can diversify around a large holding in a single security while still maintaining their desired asset allocation.

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4. Lower Cost Than Actively Managed Funds

Direct indexing generally provides customization and tax management benefits similar to a separately managed account (SMA) but at a lower cost.
The costs are closer to an index mutual fund or ETF but with the advantage of greater flexibility, control and tax efficiency from owning the securities directly.

Who Can Benefit From Direct Indexing?

Direct indexing is best suited for high net worth investors who have significant assets in taxable accounts and are looking to improve their after-tax returns. Specifically:

• Investors in higher tax brackets who can benefit more from tax-loss harvesting
• Investors who want to closely track standard indexes but make slight customizations
• Investors with concentrated stock positions seeking greater diversification in a tax-efficient manner
• Values-driven investors looking to align portfolios with ESG principles

While direct indexing costs have been dropping, it still tends to have higher account minimums than index funds. But for investors that meet the minimums, direct indexing can be an advantageous strategy that provides greater flexibility and customization.

Conclusion

Direct indexing allows investors to track standard market indexes while customizing their portfolios and improving tax efficiency. By owning the securities directly, investors get more control over their holdings leading to a truly personalized index investing experience. For high net worth investors in particular, direct indexing can be an impactful strategy for optimizing after-tax returns.