4 minute read 

This is an overview explaining Direct Indexing and how you may benefit from using this alternative, tax-aware investment strategy. 

Most of us are familiar with the term indexing when it comes to investing. It simply means mimicking a specific investment index. While there are over 5,000 different indices, the most common index investors follow is the Standard and Poor’s 500 (S&P 500). Others that are frequently displayed across your flatscreen are the NASDAQ (mostly tech companies) and the Dow Jones Industrials (DOW). For purposes of this discussion we will focus on the S&P 500, but before we move on what exactly is the S&P 500?  

Investopedia tells us that “The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.”  And Wikipedia simplifies this even further to “The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States.” 

From our vantage point we can share that over the years, the vast majority of investment managers have not been able to outperform this index. Therefore, it has become very popular to just try and simulate the performance of the index. This can be done by investing your money in an Exchange Trade Fund (ETF) or a mutual fund. These vehicles basically buy exactly what is in the index. This approach is called passive investing because there isn’t an expensive management team “trying” to pick the companies that they “think” will out-perform the index. These instruments (ETFs and mutual funds) are referred to as pooled funds because your funds are, you guessed it, pooled with other investors. 

Okay, that sets the stage for an even better way to simulate an index — Direct Indexing. It is called Direct Indexing because instead of pooling your funds with other investors you invest “directly” into the stocks making up the index in your own account. Why would you want to do that? There are some key benefits to taking this approach. First, investing within a taxable account allows for the implementation of a very valuable and possibly performance-enhancing strategy referred to as Tax Loss Harvesting.  

Tax loss harvesting is the practice of selling securities that have gone below your purchase price and locking in the loss. Now why on earth would you want to do that when the whole idea of investing is to make money? Well, I’m glad you asked. The proceeds from the sale of the security that was sold is used to buy a similar security within the index (similar risk and return characteristics) with the belief that when the market recovers the new security will recover along with the market. The result is that you get similar performance as the index, but you have booked the capital loss. The loss is a valuable tax asset because you may be able to use it to offset future gains and if you have more losses than gains in any particular year you can use up to $3,000 a year against ordinary income. If you still have losses they may carry forward indefinitely for use in future tax years. 

Most wealth and investment managers do the practice of tax loss harvesting generally once towards the end of the year. Direct Indexing uses sophisticated computer algorithms to monitor portfolios continuously looking for opportunities to harvest losses and reinvest the proceeds in securities with similar risk/return characteristics. There is an added wrinkle. The computer must keep track of the security that was sold since it cannot be repurchased for 30 days or the tax loss by law will be disallowed.   

To summarize, Direct Indexing provides an opportunity to simulate the performance of the index, remember most active managers haven’t been able to do this, plus take advantage of the tax law that allows the offset of capital gains with capital losses and if there are excess losses, they can be used up to $3,000 a year to offset ordinary income. We are very excited to be able to offer this approach to our clients.  

Another benefit of the Direct Indexing approach is that portfolios can be customized for client-specific needs, no more model (or “one-size fits all”) portfolios! Personalized factors can be used to instruct the computer what type of securities that are to be purchased.  For instance, if a client needs income, the computer can be instructed to buy securities that pay dividends or if the client would like to exclude certain securities from the portfolio for philosophical or religious reasons, the computer can be instructed to exclude certain types of companies. 

In summary, Direct Indexing allows continuous monitoring of portfolios for opportunities to harvest losses for tax purposes. It seeks to simulate the performance of an index and finally we can build very personal portfolios based on client’s specific needs or beliefs. It is worth noting that you should always consult with your tax advisor and investment advisor to determine if this strategy may benefit you.

Direct indexing is yet another way First Foundation Advisors is combining wealth planning and investments as we strive to maximize your wealth by minimizing your current taxes. 

If you would like to learn more, please visit our Tax Strategy page linked below.