Direct indexing strategies offer several key advantages for investors. Arguably two of the most prominent advantages are the ability to 1) personalize through the selection of holdings and 2) manage taxes with tax-loss harvesting. It’s rapidly becoming a mainstream investing strategy, with direct indexing assets expected to reach $800 billion by 2026 — a growth rate of 12.3% over the next 5 years that exceeds that of ETFs and mutual funds, according to Cerulli.¹
While rapidly improving technology continues to make direct indexing more accessible and cost-effective than ever, the question remains: is direct index investing worth it? The answer, it turns out, depends on a few things: investor preferences and goals, tax considerations, investment timeframe, and costs, just to name a few.
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Investor Preferences and Goals
Unlike a mutual fund where the portfolio manager decides which companies to invest in, direct indexing enables investors to simply choose the index they wish to replicate and include or exclude the securities or sectors to align with their values. This level of personalized investing is key as individuals — especially more affluent investors — expect customized experiences.
ESG investing is growing with more than 90% of S&P 500 companies now publishing ESG reports in some form.² Direct indexing technology enables advisors to finely tune the portfolios of clients who favor an ESG or values-based approach by including or excluding certain companies or sectors and find suitable replacements to maintain alignment with the chosen index. This level of customization makes direct indexing more suitable than an ETF for investors committed to this approach.
Direct indexing enables investors to own the individual securities within the portfolio, which brings an inherent set of advantages when it comes to tax management.
For investors with substantial gains in their portfolio, the ability to harvest losses can make a significant impact on their overall tax burden. Mutual fund or ETF investors can sell and replace shares at the fund level but that means they are also potentially giving up positive performers as well. Direct indexing allows investors to zero in on specific underperformers and leverage the losses to offset gains elsewhere. And those losses can be used or carried forward to offset future gains.
Direct indexing providers estimate that tax-loss harvesting could increase returns by about 1% a year.³
The strategy is consistently effective consistently across market conditions, not just when the market is up. Because direct indexing used automated trading, losses can be harvested throughout the year during volatile markets. Another tax consideration of direct indexing is the ability for investors to effectively manage taxes when transitioning from one portfolio to another.
These functions certainly make the case for leveraging direct indexing strategies with clients who have considerable tax concerns, such as more affluent investors in higher tax brackets. Any investor with sizable gains in their existing portfolio might consider direct indexing as a way to manage taxes as they transition to a more tax-efficient strategy.
Investors with shorter-term goals may not have an investment time horizon that’s long enough for the tax benefits of direct indexing to pay off. The compounding benefits of tax loss harvesting require a longer-term commitment from investors who will generally have gains to leverage.
While direct indexing costs vary, they tend to be higher than a low-cost, passive ETF — averaging around 0.40% annually compared to 0.10% for a passive, broad index ETF.⁴ Most advisors tend to recommend a strategy with some level of complexity, such as direct indexing, for more affluent investors where it’s part of an overall portfolio, and where the costs are balanced by the tax benefits.
Is direct indexing worth consideration? It certainly offers key advantages for certain investors that are looking for relatively cost-effective personalization and customization in their investments, as well as those looking for ways to manage their tax liability. To get the most out of direct indexing, and as a general rule of investing, clients should be taking a long-term approach and working with their advisor to stay on track to reach their goals.
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