Direct indexing has become a popular investment strategy, allowing investors to own individual stocks that replicate the composition of an index while gaining flexibility for tax management and customization. However, there’s a next-level approach gaining traction: direct indexing with a long-short overlay. This enhanced strategy takes direct indexing to new heights by addressing its limitations and adding performance potential.

Here’s why direct indexing with long-short strategies is a superior option:

1. Enhanced Tax Alpha

Direct indexing is well-known for generating tax alpha through tax-loss harvesting. By selling underperforming stocks to realize losses and offset taxable gains, investors can lower their tax bill. However, a long-short overlay expands this opportunity significantly:

How it works: In a long-short strategy, investors short overvalued or underperforming stocks while staying long on undervalued or outperforming ones.

The benefit: Short positions can also generate tax losses, doubling the number of tax-loss harvesting opportunities. This can significantly boost after-tax returns.^{4 5}

2. Outperformance Potential

Traditional direct indexing tracks an index, which inherently limits the portfolio’s ability to outperform the benchmark. A long-short overlay breaks free from this constraint:

Adding alpha: By shorting poorly performing or overvalued securities and reallocating to better-performing assets, the portfolio manager can aim for excess returns beyond the index.7

‍Market neutrality: A well-designed long-short strategy can generate positive returns regardless of market direction, providing diversification and reducing risk.⁷

3. Better Risk Management

Traditional direct indexing mimics the index’s risks, including market and sector-specific vulnerabilities. A long-short strategy allows for more nuanced risk management:

Hedging risks: Short positions can offset exposure to sectors or factors that might underperform, reducing overall portfolio volatility.⁷

Factor neutrality: The strategy can neutralize unwanted exposures (e.g., to value, growth, or momentum factors) by targeting specific stocks or sectors.⁷

4. True Customization

Direct indexing allows for some level of customization—such as excluding certain industries, aligning with ESG preferences, or overweighting sectors. However, long-short strategies take customization to the next level:

Dynamic adjustments: Portfolio managers can continuously adjust long and short positions based on evolving economic trends, earnings expectations, or market signals.⁷

Personalized risk-reward: Investors can fine-tune portfolios to their risk tolerance and investment goals while adding downside protection through shorting.⁷

5. Improved Efficiency in Tax Transitioning

Investors transitioning from concentrated positions or low-basis stocks often face significant tax hurdles. A long-short approach provides more flexibility in managing this transition:

Tax-advantaged selling: Losses generated from short positions can offset gains from selling concentrated holdings, reducing the overall tax burden. ⁵

Why This Matters for the Future of Investing

Direct indexing with a long-short overlay is a powerful innovation, marrying the tax benefits and customization of direct indexing with the alpha generation and risk management of long-short strategies. As investors increasingly demand tailored solutions and greater efficiency, this approach stands out as a forward-thinking strategy for both individuals and institutions.

Whether you’re aiming for enhanced after-tax returns, reduced portfolio volatility, or personalized investment outcomes, a long-short overlay can take direct indexing from good to great.

Are you ready to elevate your portfolio strategy? Let’s explore how direct indexing with a long-short component could benefit your financial plan.