The elevator pitch for direct indexing might go something like this: performance and diversification like an index fund, but you can customize the holdings and harvest losses for tax breaks.
This is all possible because with these strategies you actually own all of the underlying stocks. As a result, you can make some of the strategic moves normally reserved for your stock holdings: Managing your exposure to certain companies or sectors by selectively excluding them, say, or grabbing tax-loss opportunities by selling during market dips.
In contrast, when you buy an index fund, you're getting a slice of a fund that owns—and controls—all the underlying securities. That means you're always exposed to everything that's in the fund, whether you want it or not, and you can't use losses in the underlying securities to offset your own tax obligation.
Of course, index funds can offer plenty of simplicity and tax-efficiency on their own, which is why so many investors use them to make up the core part of their investment portfolios. Direct-indexing strategies just take these features a step further.
So, does that mean everyone should immediately open a direct indexing account? Probably not.
First, it takes a decent amount of money just to set up such an account. After all, you'll likely have to buy hundreds of individual stocks, in appropriate portions, to track your target index. Also, because these are actively managed strategies, direct-indexing portfolios come with higher fees than your average passively managed index fund.
But for some investors, the customization and tax-loss opportunities could be worth it. Here are four scenarios where direct indexing might make sense.
1. You're in a higher tax bracket (or are otherwise very tax sensitive)
If you're a high earner, using a direct-indexing portfolio for tax-loss harvesting in your taxable account can help you shield more of your dollars from taxes.
Tax-loss harvesting is when you sell a security at a loss that you can potentially use to offset other capital gains. Or, if don't have any capital gains, you can use up to $3,000 of those losses to offset your ordinary income. Either way, you end up lowering your taxes. You can then reinvest the proceeds in a similar—but not identical—holding, so your portfolio stays allocated the way you want (without violating the wash sale rule). What's more, you can also carry any unused tax losses forward to offset future capital gains.
As a reminder, investors in the highest capital gains tax bracket could face rates of up 23.8% (the 20% long-term capital gains rate, plus the 3.8% Net Investment Income Tax) on their long-term gains, while short-term capital gains could be taxed as high as the 40.8% income tax rate (the 37% short-term capital gains rate, plus the 3.8% Net Investment Income Tax), so any opportunity to shrink taxable gains could be valuable.
Here's a very simple example of what that might look like: Imagine a $100,000 portfolio consisting of 10 stocks, each with a cost basis of $10,000. Over a year, eight of the stocks rise by $2,000 each, while two fall by $2,000 each, giving us a net portfolio value of $112,000. Selling the two losers gives us a $4,000 loss we can use to offset other capital gains elsewhere in our portfolio. If there are no capital gains to offset, we can use $3,000 of the loss to reduce our ordinary income and carry forward the remaining $1,000 to offset income in a future tax year. We can then reinvest the proceeds from the sale in a similar (but not substantially identical) stock to help maintain your target allocation. In sum, we've lowered our tax bill with the loss and still have $12,000 of appreciation on the account.
These losses aren't just for your investment portfolio either. You can also use them to offset other capital gains, such as from the sale of a real estate, business, or other assets. In fact, if you know you might have a big capital gain coming in a few years, it can make sense to harvest losses well in advance, racking them until you're ready to book against that gain.
Keep in mind that tax-loss harvesting requires losers, so when the market is broadly higher, you might not have as many opportunities as when it's down. That said, historically, there have been plenty of opportunities in any given year.
Source: Bloomberg. Information taken from Schwab 1000 Index and represent holdings as of the last trading day in December of each year. Past performance is no guarantee of future results.
2. You've got stocks in a taxable account with a medium- to longer-term timeframe
Having "time in" the market gives you the potential to take advantage of the power of compound growth, as returns generate more returns, on into the future. Such compounding also applies to the extra returns you might keep when you harvest losses. In fact, routinely harvesting your losses can actually boost your after-tax returns relative to a traditional index over time.
The value of taxes saved is sometimes called "tax alpha." Think of it as the margin of extra performance relative to a strategy that is tax unaware.
Consider this example drawn from research by the Schwab Center for Financial Research: The roughly 11% average pre-tax return of the S&P 500® Total Return Index over the past 40 years would result in an average after-tax return of about 8.38% (assuming a 23.8% long-term capital gains rate). With tax-loss harvesting, however, it might be 9.41%. That's a 1.03 percentage point advantage—meaning more of the return stays invested to generate compound growth.
Source: Schwab Center for Financial Research. Hypothetical example for illustrative purposes. This information does not constitute and is not intended to be a substitute for specific individualized tax advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor or CPA. Actual after-tax returns achieved may vary due to the investor's specific tax circumstances. Clients who pay lower tax rates or who do not have offsetting capital gains and income would experience lower after-tax returns.
3. You have a concentrated stock position with significant built-in gains
Investors with large holdings in one or a few stocks can mitigate some of their concentration risk by taking advantage of two features of direct-indexing strategies: 1) They can sell down their concentrated positions while harvesting losses to offset some or all of their tax liability; and 2) they can "customize" their account by excluding stocks that would create more concentration risk.
Imagine you're an executive at a large technology company with $5 million worth of highly appreciated stock that you accumulated through corporate stock plans and incentives. You understand how risky it can be to tie your fortunes to a single stock and would like to move your assets into a broad stock market index to lower your concentration risk. You'd also like to avoid making more investments in other tech companies that would duplicate your risk.
Assuming your stock was part of the index you wanted to track, you could include some of it in a direct-indexing portfolio. The exact amount your portfolio could accommodate would depend in part on how closely you wanted your portfolio to track the target index—holding onto too much could hamper its ability to track.
Then, you could gradually sell down the rest over the course of several years. As you transitioned more of your assets into the direct-indexing account, you could theoretically offset some of your gains with the losses harvested in your direct-indexing portfolio.
4. You contribute to charity on a regular basis
Because you own the stocks in a direct-indexing portfolio, you also have more flexibility when it comes to charitable donations.
If you're active in charitable causes, you may know that donating highly appreciated stock that you've held for more than a year—as opposed to selling the stock and donating cash—can be a way to increase the value of your gift, potentially benefiting both you and the charity. It works like this: First, you potentially eliminate the capital gains tax you would incur if you sold the stock yourself and donated the proceeds. That could effectively increase the amount available for charity by up to 23.8%. Second, you may claim the fair market value of your donation as a deduction for the tax year in which the gift is made.
The rules are a little less generous for stocks you've held for one year or less. Those are considered short-term holdings, and you would only be able to deduct the purchase price, not the appreciated fair market value.
Keep in mind that the tax deduction is relevant only if you itemize on your income tax return and the donation of appreciated assets has an annual limit of 30% of your adjusted gross income.
Context matters
The potential benefits of direct indexing can be significant, but as you can see, those benefits depend on a number of factors, including your tax bracket, investment time horizon, existing investment portfolio, and preferences related to customizing index-based strategies. Talk with your advisor to learn more.
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