With a mutual fund or ETF, investors own shares of a basket of securities that tracks an index alike the S&P 500 or Russell 3000. But with a direct indexing service, investors directly own individual stocks in a separately managed account (SMA) that represents a chosen benchmark.
And since investors directly own the individual securities in their portfolios, they have opportunities for tax efficiency and customization that aren’t possible with ETFs or mutual funds.
One of the biggest opportunities that direct indexing provides is improved tax efficiency through tax-loss harvesting. Tax-loss harvesting involves selling securities at a loss, then using the proceeds of the sale to replace them with similar stocks in a portfolio. This can dramatically reduce a client’s tax bill.
See more: “Direct Indexing Use Cases Abound”
Direct indexing offers increased opportunities for tax-loss harvesting, which can help capture additional tax alpha. The technology also lets advisors guide their clients through tax-effective transitions to direct indexing. A direct indexing service like Vanguard Personalized Indexing can automatically scan portfolios for tax-loss harvesting opportunities at a set frequency. That frequency can be monthly, quarterly, or even daily.
The more frequent the scans, the higher and more consistent the tax-loss harvesting alpha. The differences in tax-loss harvesting alpha can be huge. In fact, Vanguard found that the difference can range from 20 basis points to more than 100.
Aligning Values Through Factor Tilts
Direct indexing services also allow investors to customize their portfolios to align with their values through factor tilts. According to Vanguard, advisors can tilt their clients’ portfolios so they can “express environmental, social, and governance (ESG) or socially responsible investing (SRI) preferences.”
“Because you know exactly what’s in the portfolio, you can construct completion portfolios around concentrated positions at the individual security level, while minimizing the tax impact,” Vanguard added.
Direct Indexing: An Increasingly Accessible Option
While ultra-high-net-worth investors have used direct index for years, recent developments have made this option accessible to a wider range of investors. For example, innovations in software have aided such automated processes as regular scans for TLH opportunities and rebalancing.
Plus, brokerage firms now offer commission-free trades, which has significantly reduced transaction costs. In addition, investors can now buy fractional shares of stocks, making direct indexing more affordable.
Vanguard CEO Tim Buckley said at Exchange 2023 that the company will “be investing heavily” in the direct approach to indexing. More information about VPI can be found online.
For more news, information, and analysis, visit the Direct Indexing Channel.