Direct indexing is an investment strategy that has gained traction among wealth managers and investors seeking greater tax efficiency, customization, and potential cost savings. Unlike traditional index funds or exchange-traded funds (ETFs), direct indexing allows investors to replicate the performance of a market index by directly owning the individual stocks that make up the index.
As wealth managers, we leverage direct indexing to provide our clients with a personalized and tax-efficient investment experience. One of the primary advantages of this approach is the ability to implement tax-loss harvesting strategies at the individual security level. By selling underperforming stocks and realizing losses, we can offset capital gains from other investments, potentially reducing our clients’ overall tax liabilities.
Customization is another key benefit of direct indexing. This strategy allows us to tailor portfolios to our clients’ specific preferences, values, or investment goals. We can exclude or overweight certain stocks, sectors, or industries based on their environmental, social, and governance considerations, ethical beliefs, or risk tolerance. For instance, a client who values sustainability may choose to overweight companies with strong environmental practices or exclude those involved in fossil fuel production.
Moreover, by directly owning the underlying securities, we can potentially reduce the overall costs associated with investing compared to traditional index funds or exchange-traded funds (ETFs), which charge expense ratios. This cost optimization can be particularly advantageous for clients with larger portfolios, as the savings can compound over time. This can be done for a number of indexes like the S&P 500 and the MSCI World Index.
IMPLEMENTING DIRECT INDEXING FOR CLIENTS
To implement direct indexing for our clients, we typically work with specialized platforms or providers that offer sophisticated technology and optimization algorithms. These platforms enable us to manage the complexities of direct indexing, including tax optimization, automated workflows, fractional share purchases, and ongoing rebalancing and monitoring.
For example, some platforms can store clients’ tax budgets and perform ongoing tax optimization at the individual level, considering their unique federal and state tax rates. Intuitive interfaces and automated workflows allow us to seamlessly manage direct-indexing strategies, even for complex portfolios, helping ensure scalability and ease of use.
The ability to purchase fractional shares of individual stocks or ETFs enables account managers to replicate indexes accurately, even for clients with smaller account sizes. Additionally, these platforms provide tools to monitor and rebalance direct-indexing portfolios, ensuring they remain aligned with the desired index exposure over time.
ADVANTAGES OF DIRECT INDEXING
- Tax Efficiency: Direct indexing allows for tax-loss harvesting at the individual security level, potentially generating significant tax savings over time. Investors can sell underperforming stocks to realize losses, which can be used to offset capital gains from other investments. This tax planning can be optimized and used to help offset capital gains from potential future real estate or business sales. We coordinate with our clients’ tax and legal advisors in these scenarios.
- Customization: With direct indexing, investors can tailor their portfolios by excluding or overweighting specific stocks or sectors based on their personal preferences, values, or investment goals. This can also apply to family foundations and nonprofits with specific investment restrictions or mandates.
- Potential Cost Savings: Direct indexing can be more cost-effective than traditional index funds or ETFs, as investors avoid paying expense ratios associated with those products.
- Transition Management: When transitioning clients’ existing portfolios to a direct-indexing strategy, we can thoughtfully manage the realization of taxable gains and losses, further enhancing tax efficiency. This is coordinated with our clients’ tax and legal advisors.
POTENTIAL DRAWBACKS AND CONSIDERATIONS
While direct indexing offers numerous benefits, it’s important to consider the potential drawbacks and limitations.
- Higher Minimum Investment: Direct indexing typically requires a higher minimum investment, often ranging from $100,000 to $250,000, making it less accessible to all investors.
- Complexity: Managing a direct-indexing portfolio can be more complex than investing in index funds or ETFs, as it involves monitoring and rebalancing individual stock positions.
- Limited Tax Benefits in Retirement Accounts: The tax advantages of direct indexing are primarily realized in taxable accounts, as tax-loss harvesting is not applicable in tax-deferred retirement accounts like 401(k)s or IRAs.
- Tracking Error: While direct indexing aims to replicate an index’s performance, there may be slight deviations or tracking errors due to factors like trading costs, cash holdings, and rebalancing schedules.
As wealth managers, we carefully evaluate our clients’ financial situations, investment goals, and risk tolerance to determine whether direct indexing is an appropriate strategy. By leveraging the benefits of direct indexing and working with specialized managers, we can provide our clients with a personalized and tax-efficient investment experience tailored to their unique needs.
Oppenheimer & Co. Inc. does not provide legal or tax advice, but will work with your other advisors to assure your needs are addressed. The opinions of the author expressed herein are subject to change without notice and do not necessarily reflect those of the Firm. Additional information is available upon request. Investors should review potential investments with their financial advisor for the appropriateness of that investment with their investment objectives, risk tolerances and financial circumstances. The Standard & Poor’s (S&P) 500 Index is an unmanaged index that tracks the performance of 500 widely held, large-capitalization U.S. stocks. Individuals cannot invest directly in an index. The MSCI World Index, which is part of The Modern Index Strategy, is a broad global equity benchmark that represents large and mid-cap equity performance across 23 developed market countries. It covers approximately 85% of the free float-adjusted market capitalization in each country and MSCI World benchmark does not offer exposure to emerging markets.
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Robert Dalie is a Managing Director of Investments with The Summa Group of Oppenheimer & Co. Inc. (“Oppenheimer”)
