Direct indexing, or customized indexing, is a personalized investment strategy that allows individual investors to create and manage a portfolio of individual securities, such as stocks and bonds, tailored to their specific financial goals, values, or preferences.

This approach differs from traditional index fund investing, where investors buy shares of a fund that tracks a market index. In direct indexing, investors can directly own the individual securities that make up an index or a custom portfolio, which enables them to have greater control and customization over their investments.

Benefits of Direct Indexing:

1. Tax efficiency: Investors can use tax-loss harvesting, selling individual securities that have declined in value to offset capital gains tax liabilities.
2. Customization: Direct indexing allows investors to tailor their portfolios to their unique preferences, such as incorporating environmental, social, and governance (ESG) criteria or excluding specific companies or industries.
3. Flexibility: Investors can adjust their portfolios more efficiently by buying or selling individual securities to align with their evolving investment objectives or risk tolerance.

However, direct indexing may require more investment knowledge and portfolio management expertise than traditional index fund investing. Additionally, the minimum investment requirements for direct indexing can be higher than for index funds, which could be a barrier for some investors.

Tax Alpha During the Portfolio Transition Phase

During the portfolio transition phase, direct indexing can generate tax alpha, the added value created through tax-efficient investment management. This tax advantage can help enhance after-tax returns for investors. Here’s how direct indexing generates tax alpha during the portfolio transition phase:

1. Tax-loss harvesting: When transitioning to a direct indexed portfolio, investors may realize capital losses from selling underperforming securities. These capital losses can offset realized capital gains from other investments, reducing the investor’s overall capital gains tax liability. This strategy, known as tax-loss harvesting, can be more easily implemented in a direct indexing portfolio as investors have direct control over individual securities.
2. Step-up in cost basis: A security’s cost basis is the asset’s original value for tax purposes, typically the purchase price. When transitioning a portfolio, investors can strategically sell and repurchase securities to establish a higher-cost basis. This technique, known as “stepping up” the cost basis, can result in lower future capital gains taxes when the security is eventually sold at a gain.
3. Gradual transition: Direct indexing provides the flexibility to transition a portfolio gradually. Instead of selling all the securities at once and incurring immediate tax liabilities, an investor can transition the portfolio over time. This approach can help manage the tax impact by spreading capital gains and losses across multiple tax years.
4. Asset location: Direct indexing allows investors to optimize the location of assets across taxable and tax-advantaged accounts, such as individual retirement accounts (IRAs) or 401(k)s. By placing tax-inefficient assets in tax-advantaged accounts and tax-efficient assets in taxable accounts, investors can potentially minimize the overall tax impact on their portfolios.

Tax Alpha during Portfolio Management Phase

Direct indexing can generate tax alpha by implementing tax-efficient strategies during the portfolio management and rebalancing phase. This additional value can lead to enhanced after-tax returns for investors. Here’s how direct indexing generates tax alpha during the portfolio management and rebalancing phase:

1. Tax-loss harvesting: As the portfolio is managed and rebalanced over time, investors can sell individual securities that have declined in value to realize capital losses. These losses can then offset capital gains from other investments, reducing the overall capital gains tax liability. Investors can enhance their after-tax returns by consistently monitoring the portfolio for tax-loss harvesting opportunities.
2. Selective rebalancing: Direct indexing provides greater control over portfolio rebalancing. Instead of selling all the securities in an index fund to rebalance, investors can selectively sell individual securities with the lowest tax impact. This approach can minimize the realization of capital gains, helping to reduce the overall tax burden.
3. Tax-lot optimization: When an investor owns multiple lots of the same security, each with a different cost basis, they can choose which lot to sell to optimize tax efficiency. Investors can minimize the realized capital gains and associated tax liability by selling the lots with the highest cost basis (known as “highest-in, first-out” or HIFO).
4. Deferring gains: Direct indexing allows investors to defer the realization of capital gains by postponing the sale of appreciated securities, effectively delaying the associated tax liability. This strategy can be beneficial for investors who expect to be in a lower tax bracket in the future, as they may pay a lower capital gains tax rate when the gains are eventually realized.
5. Gifting and donating appreciated securities: Direct indexing enables investors to donate, or gift appreciated securities to charities, family members, or other recipients. By doing so, they can avoid realizing capital gains on those securities, thus eliminating the associated tax liability.