Direct indexing

The capital markets have become an increasingly complex space for investors, complexities that are heightened by the sheer number of ways one can invest. Fortunately, necessity – often the mother of invention – can also be a conduit for simplification.

Enter direct indexing, an investment strategy that combines elements of earlier innovations – passive index tracking, active management, stock ownership, values-based investing and tax-loss harvesting – to give investors streamlined, tax-efficient and eminently personalizable access to the capital markets.

Direct indexing defined: As the name suggests, direct indexing is an opportunity to directly invest in the individual stocks that make up an index. Starting with a separately managed account, a professional money manager purchases a selection of stocks from a chosen index. Typically, the manager includes a representative number from each sector in an attempt to replicate the market exposure of the index on a smaller scale. For example, a manager will purchase and track not all 500 stocks in the S&P, but rather a subset of the benchmark.

Direct ownership is what distinguishes this approach from others like index-tracking funds, mutual funds or exchange-traded funds in which every investor owns the same thing. The holdings in a direct indexing strategy can be customized, allowing you to avoid stocks that don’t align with your values, goals or needs – and to increase your investment in those that do.

To accommodate this level of customization, most investment management firms require a minimum investment of $100,000 to $250,000 to create a direct indexing portfolio.

The ability to buy and sell the individual stocks using this strategy can also create the opportunity for tax-loss harvesting: selling low-performing stocks at a loss in order to help offset the capital gains on others that increase in value. Tax-loss harvesting is available under nearly all market conditions for direct indexing. That’s because even in years when your direct indexing strategy is up, some percentage of your stocks may experience losses.

“Sophisticated investors increasingly look for ways to customize their investment strategies,” said Tom Thornton, a senior vice president, whose Manager Research & Due Diligence team at Raymond James has analyzed and evaluated direct indexing managers for more than 15 years. “Direct indexing provides an opportunity for clients to tailor their portfolios to specific financial goals and personal needs.”

Financial scenarios: The high tax efficiency and customization offered by direct indexing make it useful for managing a variety of common financial scenarios, including:

Liquidity events: Proactive tax-loss harvesting can be useful ahead of substantial liquidity events, such as selling a home or business. Capital losses can be carried forward and used to offset gains from a sale, potentially reducing overall tax liability.

Assets in transition: Relocating a portfolio or transitioning assets typically carries a tax burden that tax-loss harvesting can address. An investor can sell certain positions all at once or slowly over time, and losses from sales in the original portfolio and the directly indexed account can reduce taxes on the gains from selling positions from the original portfolio.

Concentrated positions: Just as direct indexing can help an investor transition from one portfolio to another, it can also help an investor reduce a concentrated stock or sector position. If an investor holds a significant number of shares in one company or stocks in one sector with a low cost basis, any losses in a direct indexing strategy can help offset some of the gains from selling the concentrated position.

Portfolio construction: A direct-indexing strategy can be used as a core allocation within a larger portfolio – US large-caps, for example – and any losses help to offset the gains of active managers focused on other areas of the market.

Gifting assets: Another advantage of owning individual stocks through direct indexing is the ability to gift highly appreciated stock shares to a charity or heir. This allows investors to avoid the tax burden that would result from a sale while gaining a significant tax deduction. At the same time, a charity or heir receives an asset that is greater in value than the cash that would have resulted from the investor selling the asset, saving some of the proceeds to pay capital gains taxes and donating the balance.

Given that direct indexing can serve a variety of purposes and involves precisely tailored tax management, a financial advisor may know whether you need to pull this arrow from your wealth management quiver – and where to aim.

Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.

Nick Martin is a financial planner and the founder of Bluffton Financial Planning. Bluffton Financial Planning is not a registered broker/dealer, and is independent of Raymond James Financial Services. Investment advisory services offered through Raymond James Financial Services Advisors, Inc.