Direct indexing involves an investor buying an equity index directly, rather than through a fund. There are many reasons why an investor may want to engage in this strategy, from expressing ESG preferences to counterbalancing a large position in a portfolio to tax reduction.
Direct indexing can be useful for investors holding significant amounts of tax-inefficient investments in taxable accounts. But its effectiveness can vary widely depending on the circumstances. So, Morningstar’s director of research John Rekenthaler has listed eight factors in which direct indexing can be effective and ideal for investors.
High Federal Tax Bracket
Rekenthaler argued that the higher the federal tax bracket, the greater the potential benefit direct indexing can provide.
High State Tax Bracket
Likewise with state tax brackets: the higher the better. So, if all things are equal, direct indexing may benefit investors based in California more than Florida.
Large Investment Pool
The more money in the investment pool used for direct indexing, the more likely that pool can offset capital gains.
Steady Replenishment of Assets
The more frequently the directly indexed pool is replenished with new assets, the better it can offset capital gains, since new assets should boast a relatively high cost basis.
See more: “4 Use Cases for Direct Indexing”
Schedule D Capital Gains
Rekenthaler noted that short-term capital gains from some types of investments appear on Schedule D of the federal tax form, while those from other investment types do not.
Short-Term Capital Gains
The short-term capital gains that appear on Schedule D are taxed at a higher rate than long-term gains, which makes them benefit more from direct indexing.
Volatile Markets
Not surprisingly, choppy markets offer a greater potential for capital losses than an ongoing bull market. So, a volatile market environment is one in which direct indexing can benefit the investor.
Pre-Liquidation
As tax-reduction methods are generally tax-postponement techniques, their effects are strongest for portfolios that are retained rather than liquidated. So, direct indexing is especially well-suited for assets that are to be either donated or passed down to heirs.
While Vanguard CEO Tim Buckley said at Exchange that direct indexing “was reserved for the ultra, ultra high net worth” investor, its use cases could be expanding to a broader investor base. Buckley added that direct indexing is something that the company will “be investing heavily” in.
For high-net-worth clients with significant capital gains, Vanguard Personalized Indexing can automatically scan portfolios each day for tax-loss harvesting and rebalancing opportunities. More information on Vanguard Personalized Indexing can be found online.
For more news, information, and analysis, visit the Direct Indexing Channel.