Part II: Why Direct Indexing Might Make Sense For You
In our previous post, we explored the rise of direct or personalized indexing and identified how investors who take that path are signing up to directly own the underlying shares of securities that approximate, or fully comprise an index. With a universe of low-cost mutual funds and/or exchange traded funds (ETFs) that track indexes, one might reasonably ask: what is the benefit of Direct Indexing relative to the many other options available?
The true benefit of Direct Indexing for an individual investor comes in the form of enhanced customization, particularly when it comes to improving outcomes in leveraging tax efficiencies.
Direct indexing’s most quantifiable value is tax optimization and the resultant tax savings. Research suggests that investors can realize higher returns by selling losing securities and using (or “harvesting”) the losses to offset the capital-gains tax liability from winning securities.
Tax-loss harvesting is not a new concept. For years institutions and wealthy investors have engaged in selling some stocks or assets that have fallen in value and using the losses to help offset capital-gains tax liability, reducing the overall tax bill. However, historically this has been an inefficient process that has involved finding and selling these positions manually. Further, the benefit was quite sensitive to when the harvesting process occurred (example: doing it at the end of the year presumes that specific holdings were down in 4thquarter and excludes temporary losses that might have occurred earlier in the year). Thanks to advances in technology, this process can now be executed efficiently on an ongoing basis, maximizing the overall benefit (as you can see from the chart below its estimated this can add anywhere from .40% to over 4% per year to overall returns depending on the market environment and individual’s tax situation).
Source: Derek Horstmeyer “Just How Valuable is Tax-Loss Harvesting” Wall Street Journal, 4 Dec 2021
Another tax-efficient feature of direct indexing involves individual securities holdings. For those investors who already have a potential tax-liability from a long-term holding with a low cost basis, or significant wealth in the form of equity compensation from a publicly traded company, direct indexing can be a way to facilitate a plan to slowly exit a highly appreciated or concentrated equity position.
For those investors who have significant assets in taxable accounts, or are tax-sensitive in general, direct indexing can be a solution worth exploring.
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