4030 Smith Rd., Suite 200, Cincinnati, OH 45209

Direct Indexing – The Tax Savvy Investment Strategy

Stock Chart

Direct indexing is the hottest trend disrupting the investment world and looks like it is here to stay. Direct indexing is not new and has been around since 1992 by certain money managers. However, because of recent events it is becoming more and more popular and gaining adoption by some of the largest brokerage firms in the world. Due to free trades and advances in technology the implementation of direct indexing is becoming much easier than it was in the past.

 

What is Direct Indexing?

Direct indexing is the practice of purchasing and owning the underlying individual securities that make up an index. Where Exchange Traded Funds and Mutual funds set out to own an entire index by holding them in one single fund, direct indexing does the opposite. Direct indexing is a customizable approach and instead will hold the positions individually, offering much more customization and transparency. The direct indexing portfolio will not own every single stock in the index, instead it will own the stocks that represent the same exposure as that index. For example: a direct indexing portfolio that tracks the S&P 500 would not own all 500 stocks, instead, it owns 100 stocks representing the same exposure and risk as owning all 500 stocks.  Due to some of the benefits of direct indexing more and more brokerage firms are starting to offer this to their clients, such as Fidelity, Charles Schwab, and BlackRock.

 

Even though this concept has been around for decades it has not gain wide adoption by investors. This can be a pain staking process to manage and maintain. Also, investors may be averse to owning 300 individual stocks in their portfolio. However, through free trades, digital investing platforms and fractional share trading direct indexing is becoming more broadly accepted.

 

Benefits of Direct Indexing

So why are investors turning to direct indexing? One of the main reasons to implement these strategies is for the tax advantages. When you invest in an index the return you get is driven by the performance of the stocks it owns. Within an ETF you simply get the performance of that fund, meaning one investment. However, on a year-by-year basis, even when the S&P 500 index has a positive return on the year, not all of those individual stocks were up that year. This article from Kiplinger gives a great breakdown of all the stocks in the S&P 500 in the year 2020 and their performance. https://www.kiplinger.com/investing/stocks/602021/the-best-and-worst-sp-500-stocks-from-2020

 

As you can see there were a large number of stocks that had a negative return on the year. Some of the worst performing stocks were in the cruise, oil, and airline industries. Carnival Corporation (CCL) ended the year down 56.9%. while the best performing stock in the index, Tesla (TLSA), was up 743.4%. Any investor than owned an S&P 500 ETF or mutual fund would have seen an overall return close to 16%. The way direct indexing works is that by owning these individual positions you can offset the gains from one stock by selling your losses in another stock. You can continue to do this throughout the year and lead to a higher real return due to the tax savings.

 

This can be especially beneficial for investors with high concentration in a single stock with very large gains. By owning the index, you can eventually harvest enough losses from your other positions to sell down your highly concentrated stock without paying a large amount in taxes. You can also still get the upside and dividends of the stocks that do perform well on a year-by-year basis.

 

Two other benefits of direct indexing are diversification and customization. Here is an example of how this can add diversification. Take an executive or someone that works for a publicly traded company and is awarded shares in their company. If they were to also own an S&P 500 index fund, they would also own shares of that company via the index. However, through direct indexing they can avoid investing in that position within their customized portfolio. Secondly, if an investor feels strongly about not investing in a certain company based on personal beliefs, they can simply choose to not add that company to their portfolio.

 

Even with the advances in technology, direct indexing can still be complicated to understand and implement. However, for the right investor this can be a game changing strategy for their long-term investments.