What is Direct Indexing? – Forbes Advisor


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Direct indexing is the construction of a personalized investment portfolio that mirrors the composition of an index. Once the exclusive domain of wealthy clients, direct indexing has become cheaper and more accessible than ever thanks to better technology and ever lower trading commissions.

How direct indexing works

Direct indexing consists of buying the underlying securities that make up an index, with the aim of duplicating the performance of the index.

Sound familiar? Direct indexing uses a similar approach to index funds and exchange traded funds (AND F). But because you’re buying individual stocks rather than a unified fund product, you get added flexibility to customize your portfolio, allowing you to take advantage of potential tax advantages and filter out unsavory or unwanted stocks that you cannot when you buy a wholesale fund.

Tax loss harvesting is the superpower of direct indexation

Tax loss harvest it is when you sell assets that have fallen in value to offset current or future gains from other sources. You can then replace the assets you are selling with similar, but not identical, investments to position yourself for a rebound in the asset class.

With a normal index fund, you might be able to do this at the fund level, meaning you could sell an underperforming index fund and replace it with a fund that tracks another index. But you can’t focus on individual winners or losers, which makes your harvest much less accurate. Perhaps a few stocks out of a hundred are responsible for a huge drop in a fund’s performance. With an index fund, you are forced into an all-or-nothing approach.

However, when you have personally recreated an index using direct indexing, you can sell those underperforming individual stocks. Then, with the money you get back, you can buy shares of similar companies to balance out your portfolio allocations. In the meantime, you have generated a capital loss which you can use to reduce your overall tax payable.

It is important to note that not everyone can benefit from tax-loss harvesting. In 2021, investors earning $40,000 or less are not liable for long-term capital gains taxes, for example. This means that if you’ve held shares for at least a year, you don’t pay anything on your earnings anyway, so you won’t benefit from realizing any losses on your investments, at least not in terms of your investment income. . For similar reasons, direct indexing is not relevant for tax-advantaged retirement accounts, such as a 401(k) or one individual retirement account (IRA).

However, the strategy has been shown to work consistently in all market conditions. The benefits can be significant even when the market is generally up. Bloomberg reports that direct indexing providers estimate that this type of tax loss could increase returns by around 1% per year.

Direct indexing is the perfect tool for SRI and ESG

Direct indexing gives you the ability to choose – or more commonly, reject – individual companies that don’t meet your personal, ethical or other standards. Faith-based investors may reject VP-based stocks, and environmental investors may, for example, go green in favor of a coal or nuclear power generator.

If this sounds familiar, it’s probably because it’s an integral part of ESG investing, a subset of socially responsible investment (SRI) which actively selects companies based on their score on third-party criteria related to their environmental, societal and governance policies and behaviors. Direct indexing based on the ESG can allow you to customize a major index, such as the S&P500 or the Dow Jones Industrial Average (DJIA). Suppose you like DJIA but don’t want to support oil and gas giant Chevron (CLC), a DJIA component. Direct ESG-based indexing would allow you to buy 29 of the 30 companies that make up Dow but ignore CVX.

With direct indexing, you are also in a better position to engage in shareholder activism. If, for example, a company recklessly plunges a tanker into a fragile ecosystem, it can be punished immediately when you can sell your holdings. If you choose to keep your shares, you can also more easily voice your concerns by exercising your voting rights in a more difficult way when you indirectly own shares of a company through an index fund.

How to get started with direct indexing

In the past, direct indexing was only open to the wealthiest investors. It took a huge commitment of $1 million or more to buy, and even today some direct indexing strategies require $250,000 or $500,000 as a minimum investment.
But technology and new industry practices have brought direct indexing within reach of average investors.

Robo-advisor wealth front offers free direct indexing, which it calls “stock-level tax loss harvesting,” for clients with at least $100,000. Plus, as fractional shares and no-fee trading become more mainstream at brokerages like Robinhood, Charles Schwab, and Fidelity, it’s becoming easier for ordinary investors to build their own micro-versions. direct indexing, if they’re willing to put in the time. and energy to manage a portfolio of hundreds of potential stocks.

Due to the amount of legwork involved, direct indexing may work even better for informed clients with at least moderate sums to invest, but certainly not the millions once required. Small investors and anyone still getting used to the stock market may prefer traditional ETFs and index funds, which offer an easy, inexpensive, and proven route to positive returns.


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