Tax-Efficient Investing with Direct Indexing

July 02, 2023

Investing in the stock market is one of the most popular ways to grow wealth and achieve financial goals. Traditionally, investors have relied on mutual funds, exchange-traded funds (ETFs), or individual stock picking to build their portfolios. However, due to fee compression ($0 trade costs at Schwab) at custodians and trading tools technology developments, a new strategy called Direct Indexing offers investors a cost-effective, tax-efficient, personalized approach to wealth accumulation. In this blog post, we will explore the concept of direct indexing, its benefits, and why it has the potential to reshape the taxable investment landscape for investors.

Understanding Direct Indexing:

Index investing, which Jack Bogel and Vanguard Investments popularized, is a passive investment strategy that seeks to replicate the returns of a benchmark index. Until recently, investors could only do this by purchasing a Mutual Fund or an Exchange Traded Fund (ETF). Direct indexing replicates the concept by tracking an index. However, with Direct Indexing, investors own individual securities instead of the Mutual Fund or ETF. Direct Indexing is when investors build their own index by purchasing the underlying stocks directly.

How Does Direct Indexing Work?

Direct indexing works by leveraging technology and sophisticated algorithms to replicate the performance of a specific index. Investors work with asset management firms or boutique Wealth Management firms like Pleasant Street Wealth Advisors, which offer direct indexing services to construct and manage portfolios. These platforms often provide tools and resources to customize the portfolio according to the investor’s preferences, such as tax optimization, sector allocation, and environmental, social, and governance (ESG) considerations.

Benefits of Direct Indexing:

Customization: Direct indexing provides investors with unparalleled customization options. Unlike traditional index funds or ETFs, investors have the flexibility to exclude specific stocks from their portfolios, align their investments with personal values or beliefs, or overweight sectors they believe will outperform. Employees of large publicly traded organizations who receive significant equity compensation can underweight their employer’s stock to prevent concentration within their household.

Tax Efficiency: One of the significant advantages of direct indexing is its potential for tax optimization. By owning individual securities, investors can selectively harvest tax losses at the stock level, offsetting gains in other areas of their portfolio. This strategy can help minimize tax liabilities and potentially increase after-tax returns. For passive investors who own ETFs or Mutual Funds, this level of tax efficiency is unattainable.

Cost Savings: Direct indexing eliminates the need for fund management fees associated with traditional index funds or ETFs. At the same time, there may be some costs associated with the platform. At Pleasant Street Wealth Advisors, our Direct Indexing platform fees are lower than many ETFs and almost all Mutual Fund management fees. The low-cost structure is a cost-effective alternative for long-term investors who currently hold ETFs and Mutual Funds.

Thematic Considerations: Direct indexing allows investors to integrate investment themes they believe in. Common examples our clients have selected are ESG environmental, social, and governance, BioTech, and Cybersecurity. It enables them to exclude companies that do not align with their values or allocate capital toward businesses that share their values or enterprises operating in exciting industries.

Transparency and Control: By directly owning individual securities, investors have complete visibility into the holdings of their portfolios. They can make informed investment decisions, understand the risk exposures, and have better control over their investments.

Direct indexing represents a significant shift in the world of investing, offering individuals an innovative and personalized approach to constructing their portfolios. With customization options, tax efficiency, and the ability to align investments with personal values, direct indexing has the potential to reshape the investment landscape. However, like any investment strategy, evaluating individual circumstances is crucial, consulting with financial professionals, and conducting thorough research before incorporating direct indexing into an investment plan. If you are interested in learning more about Direct Indexing and how incorporating the strategy might enhance your financial plan, use the link below to schedule a meeting and learn more!