A direct indexing portfolio is a separately managed account based on a benchmark index. Since investors have direct ownership of the individual stocks in their portfolios, they gain opportunities for tax efficiency and personalization that may not be possible with ETFs and mutual funds.
While direct indexing can help solve some complex financial challenges for investors, the strategy isn’t a good fit for everyone. So, Vanguard listed four primary use cases where this strategy could add real value for investors.
Tax-Loss Harvesting
With direct indexing portfolios, investors directly own the stocks within. This lets them sell individual securities in the portfolio at a loss, even during years when the benchmark index’s return is positive. Harvesting tax losses in this way can help offset capital gains at tax time — and help increase their after-tax returns.
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. Meanwhile, the tax efficiency may not outweigh the additional cost and complexity for lower-net-worth investors.
See More: “Direct Indexing Shouldn’t Just Be for High Net Worth Clients“
Expressing Environmental, Social, and Governance (ESG) Preferences
Some ESG-focused investors have specific criteria for seeing their personal preferences reflected in their investments that can’t be met with off-the-shelf ETFs and mutual funds. Vanguard Personalized Indexing can screen out specific companies, sectors, or industries from a portfolio. It can also tilt the portfolio to improve its focus on topics that are important to the investor, such as weighting the portfolio with companies that are moving toward a lower carbon footprint.
Factor Investing
For investors who want to overweight their portfolios toward companies with certain factors such as value or momentum, prepackaged ETFs can often be a good option. However, some may have customization needs that prohibit using off-the-shelf ETFs. In those cases, direct indexing could be the right option. One example where direct indexing can help is when an investor wants to use a combination of factors or to apply those factors in a way that doesn’t already exist as a prepackaged solution.
Diversification
Direct indexing can serve as a tax-efficient way to transition to a diversified portfolio if an investor’s portfolio has a concentrated position or a large amount of highly appreciated stock. As an investor’s concentrated position is progressively sold into a more diversified direct indexing portfolio, harvested losses can be used to offset capital gains generated by those sales.
More information on Vanguard Personalized Indexing can be found online.
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