What is Direct Indexing? Customization, Taxes, and More

Direct Indexing vs ETFs: Customization Benefits

Traditionally, the cheap and easy way to manage a diversified stock portfolio is to buy a passive exchange-traded fund (ETF) or a mutual fund that is just mirroring a chosen index. In this case, you are buying into the fund’s strategy, and it’s not going to factor in each individual investor’s wants and needs. In other words, when purchasing an ETF or mutual fund, you don’t get any input on the underlying securities being purchased by the fund.

For example, let’s say you work for a major company that’s in the S&P 500 index, and you already have a large position to the company’s stock in your employer retirement plan.

If you want to purchase broad equity market exposure through any number of ETFs tracking the S&P 500 Index, can you have them exclude that particular company’s ticker? The answer is no. If you buy the fund, you are getting exposure to the stock. You have no say of what goes into the fund. In that sense, ETFs and mutual funds generally aren’t flexible to each investor’s unique circumstances.

At its core, direct indexing allows investors to cost effectively customize their investing strategies like never before. Direct indexing uses individual stocks to mimic the risk and return of completely passive indices, active factor-based strategies, or combinations of both.

This works because you don’t necessarily need to own every company in an index to have a portfolio with very similar risk and return metrics over time. Using the S&P 500 as an example, you can get similar amounts of risk and return for your portfolio without owning all 500 companies that make up the index. You may only need to own 100 to 250 of the companies to achieve your desired allocations and goals. You can own substantially fewer than 500 stocks and still achieve the vast majority of the desired risk and return “exposures.”

Because you don’t have to always own every single holding in an index to achieve an index-like allocation, that opens the door to customizing your holdings. It gives each investor the ability to set unique portfolio parameters including ESG considerations, specific security restrictions and unique tax or capital gains budgets, by more effectively managing the underlying individual holdings inside an account.

Direct Indexing: Tax Loss Harvesting Opportunities

There are many benefits to a direct index trading strategy, but the most powerful may be the tax efficiencies created from active tax-loss harvesting. Direct indexing gives a portfolio the ability to frequently tax-loss harvest by realizing losses from selling any of the underlying individual stocks trading at a material loss, and immediately reinvesting the proceeds to other stocks that fit within the current strategy’s allocation.

For instance, if Target ($TGT) stock decreases in value, you could consider selling that position at a loss, and book a tax-loss for your account. With direct indexing, you can take action to book that loss because you own the individual $TGT shares in your account.

But if you own shares in a passively managed ETF or mutual fund that is only mirroring an index, like $SPY, there is no way for you as an individual to take advantage of the downward move in Target. You don’t actually own any $TGT shares instead just shares of $SPY, which probably wouldn’t be too affected by Target’s move alone.

Now that the sale is complete and a tax-loss is booked, we need to get the proceeds from that sale reinvested back into the current strategy ASAP. In our Target example, sometimes it’s as simple as buying Walmart ($WMT) to preserve the portfolio’s allocation. Sometimes it might be better to buy smaller amounts of five other individual stocks across various sectors that fit within the portfolio’s overall strategy. Either way, you must be careful about what you purchase to avoid wash sales.

How to Use a Direct Indexing Strategy

Direct indexing is true portfolio customization on every level. It works around your annual tax or capital gains budgets and any unique securities preferences and restrictions, while also managing the ongoing trading activity to optimize tax losses and avoid wash sales.

Direct indexing is a powerful strategy when put to work correctly in your portfolio. Thanks to improvements in direct indexing technology, you don’t have to settle for investing in an ETF or mutual fund that might be “close enough” to your goals and values. Many investors are considering some form of direct indexing in their portfolio.

There are many direct indexing providers out there. Monument implements direct indexing strategies through our Tax Rebalanced Index Optimization (TRIO™) accounts, which utilize the Canvas™ technology suite operated by O’Shaughnessy Asset Management (OSAM). We run TRIO™ across various investment styles and mandates and build our custom TRIO™ strategies based on each client’s expressed wants and needs.

Check out our recent podcast with Pat McStay from OSAM to learn more about how their robust software makes running direct indexing strategies easy for our clients.