Customized products and experiences are trending these days. Even in stock investing, investors can now “customize” and personalize their stock portfolios. This is called direct indexing.
A direct index is a slightly more complex version of an investment fund, index fund, or exchange traded fund (ETF). Direct indexes have advantages not available with other types of funds. One advantage is that direct indexing gives investors more flexibility in selecting or managing individual stocks in their portfolios.
This article details direct indexing and answers questions such as: Is direct indexing worth it, the benefits of direct indexing, the cost of direct indexing, and other important insights.
Direct Indexing Overview
Direct Indexing is an investment strategy that was previously reserved for wealthy investors. Previously, this strategy was only available to those with at least $1 million in investment capital, as direct indexing required paying high fees. Usually this also means buying shares with equal weight, so imagine the cost of that.
Thanks to online brokerage platforms (and many his RIA managers) that offer commission-free trading, investors no longer need to be millionaires to index directly. Investors with as little as $5,000 can use direct indexing to mimic indexes like the S&P500 or the Russell 2000.
How Direct Indexing Works
An investor instructs a financial advisor or investment manager to purchase stocks that reflect the selected index through a separately managed account, or SMA. And rather than buying mutual funds or ETFs to try to match the performance of a stock index, investors simply buy a small portion of individual stocks to mimic the index.
When investors buy individual stocks, they can now adjust their portfolios to exclude stocks in companies that do not align with their views and financial goals.
What are the advantages and disadvantages of direct indexing?
Investors choose this investment strategy because of its potential advantages. Here are some of the benefits of direct indexing:
Advantages of Direct Indexing
1. Portfolio customization
This is the main advantage of direct indexing. Investors can decide which individual stocks to invest in, giving them more control over their stock portfolio. They can choose stocks that suit their financial goals and preferences.
Jack Bogle, the famous “father of mutual funds,” made it easy for investors and advisors to aggregate mutual fund stocks. So why bother creating a direct index? It’s simply because of the benefits of ESG investing, the high degree of portfolio individualization, and portfolio risk mitigation. Watch the video to learn more.
2. Increased tax efficiency and savings
Direct indexing allows investors to control when and how to realize capital gains from transactions. Investors may be able to reduce their year-end tax liability by using tax losses to offset profits. Investors can also delay realizing profits and wait for a more favorable tax year.
3. Promoting ESG investing
Direct indexing gives investors more control over their stock portfolios, allowing them to include or exclude individual stocks.
Compared to mutual funds or ETFs, direct indexing allows investors to filter out stocks that are not aligned with their values. This can be a good way for investors to build an ethical investment portfolio. For example, they can remove or avoid individual securities of tobacco companies, weapons manufacturers, or companies with reported environmental damage or human rights violations.
4. Improved Risk Management
Another important benefit of direct indexing is improved risk management. Direct indexing means owning individual stocks, so clients can easily diversify their portfolios. This may reduce exposure to risks specific to a particular industry or company.
Direct indexing allows advisors to customize their clients’ portfolios based on their individual risk tolerance and investment goals, giving them greater control over their investments.
5. More profitable philanthropy
Giving money to charity using a directly indexed portfolio is not only easier, but can also provide investors with tax breaks. You can also gift stocks instead of money and pay taxes accordingly. Investors may be able to pay less taxes on their behalf while supporting causes that reflect their values.
On the other hand, investors should also be aware of the risks and disadvantages of direct index investing. Aside from some confusion about the name itself, direct indexing is not without its flaws.
Disadvantages of Direct Indexing
1. No Benefits for Retirement Accounts
One disadvantage of direct indexing is that you cannot deduct losses from your 401(k) plan or IRA. You cannot deduct losses from these tax-free accounts. However, retirement accounts benefit from the ability to implement a variety of “screenings,” including ESG.
2. This is subject to the “wash sale rule.”
The wash sale rule provides that an investor who sells a stock at a loss and purchases the same or identical security within 30 days before or after the sale will report this on his or her tax return. You cannot declare a loss on this stock in the same year. However, most established direct index providers have systems in place to circumvent these wash sale rules.
3. There are restrictions on offsetting profits
Long-term losses from investments held for more than one year can only be offset by long-term gains. The same applies to short-term losses. Only short-term gains can offset that. If an investor experiences excessive losses in one investment category, they can offset them with gains in both investment types.
4. Minimum initial investment can be high
Previously, investors needed at least $1 million to use a direct index strategy. However, although it is now possible to invest directly in an index with much less capital, the need is still great. Some direct index investing services may still cost him $100,000 to $200,000. At least one financial institution, Fidelity, offers direct index portfolios for as little as $5,000.
What is tax loss recovery in direct indexing?
Loss recovery is the acquisition of securities at a loss so that you or your client can use the loss to offset other capital gains. It’s a process of selling.
Investors who experience no capital gains can use up to $3,000 of their losses to offset their ordinary income taxes. This means you pay less tax in both cases.
The proceeds can then be reinvested in similar (but not identical) investments so that the portfolio is allocated as intended without violating wash sale rules.
Tax loss recovery also allows investors to carry forward unused tax losses to offset future capital gains.
Who should consider direct indexing?
Considering the advantages, disadvantages, and opportunities that direct indexing offers, is direct indexing a worthwhile investment strategy, especially for beginners? How investors can benefit from direct indexing Here are some likely scenarios:
1. High-income investors
High-income investors can make large profits from losses. This effectively protects more investor funds from tax increases. Note that investors in the highest capital gains tax bracket must pay up to 23.8% on long-term gains (20% long-term capital gains rate and 3.8% net investment tax).
Short-term capital gains, on the other hand, are taxed up to an income tax rate of 40.8% (short-term capital gains tax rate of 37% plus a net investment tax of 3.8%). If your client falls into this tax bracket, the opportunity to reduce their taxable profits will definitely be welcomed.
2. Investors who hold stocks in a taxable account but have a long time horizon
The more time an investor invests in the stock market, the more growth the investor gets. Compound interest refers to the additional profit an investor receives if he or she incurs a loss. Regular use of losses from direct indexes can increase after-tax returns compared to traditional index returns.
3. Investors with concentrated stock positions that generate large profits
Investors with large stakes in one or more companies can use direct index strategies to reduce risk. This means you may need to sell some of your concentrated stock positions to offset your tax liability and adjust your portfolio to exclude riskier stocks.
For example, if an investor invested her $3 million in the stock of one technology company, she could move that asset into a broad stock index to reduce risk. Direct indexing allows you to gradually sell portions of your stocks over time while offsetting gains and losses from your directly indexed portfolio.
4. Investors who regularly donate to charity
Owners of directly indexed portfolio stocks have more flexibility in supporting causes they believe in. They donate valuable stocks (instead of selling them) that they have held for more than a year. That and donations of money) can increase the value of the gift for both the investor and the beneficiary.
By donating shares directly, you can avoid paying capital gains tax and increase the amount available to charity by up to 23.8%. Additionally, investors can claim the fair market value of their shares as a tax deduction in the year they make the gift.
For inventory held for less than one year, only the purchase price can be deducted, not the estimated price. The tax credit only applies when reported on the tax return, and gifts of appreciated property are subject to a 30% of adjusted gross income limit.
Beginners are lucky to be able to try this investment strategy because the cost of entry is no longer as high as it used to be. Although direct indexing is a useful investment strategy with tax benefits, it is not suitable for everyone. Investors should first consider other factors such as risk tolerance, financial goals, and time horizon before applying this strategy to their stock portfolio.
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