What is Direct Indexing?
What is Direct Indexing? It is a powerful investment technique that offers investors diversified, index-like returns with several key benefits, including tax savings, flexibility, and the ability to tailor a portfolio to specific investment objectives.
To implement this strategy, an investor constructs a customized portfolio by purchasing individual securities directly, typically stocks, that mirror a benchmark index or specific investment theme. The objective of direct indexing is to achieve greater control over the portfolio and to potentially generate better returns (and lower taxes) compared to investing in an index fund or an exchange-traded fund (ETF).
Benefits of Direct Indexing
Tax Efficiency
One of the significant advantages of direct indexing is the ability to harvest tax losses. Even if an index such as the S&P 500 has had a positive return for the year, some of its constituent stocks will almost always be down. Direct indexing allows investors to selectively sell individual stocks in their portfolios to offset capital gains and reduce taxes, thereby improving their after-tax returns by as much as 1%.
Source: https://www.parametricportfolio.com/blog/direct-indexing
Diversification of Concentrated Positions
Direct indexing also helps overcome the challenge of diversifying concentrated equity compensation positions. Many investors may have a significant portion of their net worth tied up in a single stock, such as company stock options or restricted stock units (RSUs). With direct indexing, investors can customize their portfolios to account for the specific stocks they already own, achieving greater diversification while still retaining exposure to their concentrated positions.
Challenges of Direct Indexing
However, direct indexing requires more time and effort to manage than investing in a passive index fund. Investors need to select and monitor individual stocks, which can be time-consuming and require more investment expertise. Additionally, investors must be mindful of potential wash sale restrictions when tax loss harvesting.
So, what is direct indexing? Well it’s an effective investment strategy for investors looking to achieve greater diversification and potentially reduce their tax liability. While there are potential drawbacks to direct indexing, the benefits outweigh the costs for many investors.
If you are interested in exploring a direct indexing strategy further, please feel free to reach out to us with any questions.
Forrest Financial Partners does not provide specific legal or tax advice. Please consult with professionals in these areas for specific legal and tax recommendations. The information provided herein is general information. It is not intended to be construed as investment, tax, or legal advice. Information in this article is not an offer or solicitation to purchase, sell, or endorse a specific company, security, investment vehicle or strategy. Investing involves risk and the possible chance for loss of principal. Please consider your tolerance for risk before investing. Past performance is never guaranteed and future results can vary. Opinions conveyed by Forrest Financial Partners cannot be viewed as an indicator of future performance and are subject to change. Results may vary. Use information at your own risk.
