Once an obscure investment strategy used only by the ultrawealthy, direct indexing has emerged in recent years as a way for mass market investors to tap into what might be dubbed the "all about me" stock portfolio.
The idea is that an investor doesn't have to settle for off-the-rack mutual or exchange-traded funds; instead, she can customize things according to her values (no oil drilling companies, for example). Along the way, she can also eke out extra profits from a tax strategy focused on culling losing bets to offset the gains on winning ones.
But it's not the allure of personalized stock picking that's driving investors to direct indexing, now
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Direct indexing, whose accounts Morningstar said held $260 billion in assets at the end last year, comes in two flavors. One approach involves choosing an existing benchmark, such as the S&P 500 index or Russell 3000, then buying its stocks in proportional amounts and holding them in a taxable brokerage account.
A more bespoke approach involves creating your own index — say, of companies that approve the most shareholder proposals — then purchasing their shares. For example, environmental, social and governance investments "can mean pretty much anything," Morningstar said, but with direct indexing, "investors can focus on the aspects of ESG investing that mean the most to them."
Why not just buy a mutual or exchange-traded fund that tracks a given index? Especially since many ETFs also deploy the same tax tricks?
Because owning those funds doesn't give an investor the ability to nudge up their profits by actively engaging in tax-loss harvesting. That strategy involves an investor intentionally selling positions that have declined, recognizing the losses for tax purposes, then using those losses to offset taxable capital gains on other positions, including on assets held outside the portfolio.
Investors can earn an extra 1%-2% a year of additional return, with high net worth investors in the top 37% tax bracket getting the largest benefit, Morningstar said.
Not all tax-loss harvesting is equal
The extra boost comes because the tax code allows investors to use realized losses, meaning losses not on paper but actually taken, to offset an unlimited amount of realized capital gains, dollar for dollar. Any unused losses can be carried forward indefinitely to likewise reduce the taxes owed on investment gains. If there aren't enough gains to soak up losses in a given year, an investor can use up to $3,000 of losses to offset, meaning reduce the taxes owed on, ordinary income, like salaries.
When the manager of an ETF harvests losses in the fund, the move doesn't change an investor's cost basis, or original purchase price of the fund, the key element that determines how much tax the investor will owe when selling the fund. Instead, the tax benefit of the move comes from the fund not throwing off taxable capital gains distributions, like mutual funds do.
By contrast, an investor who harvests losses in a direct indexed portfolio can capture directly the tax benefits for her bottom line.
The S&P 500 is up more than 7% so far this year. But 83% of that gain comes from just 7 stocks: Apple, Microsoft, Nvidia, Tesla, Meta (Facebook), Alphabet (Google) and Amazon, said Scott Bishop, the executive director of wealth solutions at Avidian Wealth Solutions in Houston.
If you own an ETF tracking that 500-stock benchmark, you can't harvest individual losses from hundreds of stocks. But if you own the equivalent through a direct indexing portfolio, "you can play that path," Bishop said. "It's something that actually for large investors with after-tax money can actually be very tax efficient."
Other key takeaways in the Morningstar study:
'The direct indexing arms race'
"The growing popularity of direct indexing set off a wave of acquisitions by some of the largest asset managers." Vanguard bought Just Invest in late 2021 to jump-start its direct indexing offerings. It was the first acquisition in Vanguard's 47-year history; now called Vanguard Personalized Indexing Management, the unit marks the fund giant's ambitious plan to expand in the niche.
Other recent direct indexing acquisitions by wealth management companies: JP Morgan bought tax-focused financial technology firm 55ip at the end of 2020; Morgan Stanley snapped up Eaton Vance and its subsidiary Parametric Portfolio Associates, the biggest direct indexer by assets, in 2021; BlackRock acquired Aperio, the second-largest direct indexer, that year.
"Other firms are either building their own offerings or forging strategic partnerships. Charles Schwab built its direct indexing service on its brokerage platform in 2022, for example, and both Natixis Investment Managers and Principal Asset Management have cooperated with smaller firms to create their services."
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Fees
Fees for directing indexing investments are generally higher than those for mutual funds and ETFs. According to Morningstar's survey of some of the largest direct indexing providers — it didn't name companies — starting expenses among surveyed providers range from 0.25% for minimum investments of $250,000 up to 0.40% for firms targeting smaller accounts.
Most fees for U.S. large-cap indexes begin in the 0.20%- 0.40% range and decrease as account balances grow. At Schwab, fees fall to 0.35% from 0.40% once an account has more than $2 million. Fees are typically higher for international or hyperspecialized niche indexes.
Taxes and the 'secret sauce'
Morningstar said that most direct index providers have published studies showing that investors can expect to add an additional 1 to 2 percentage points of return annually by using tax-loss harvesting. "There are always losses somewhere," it wrote.
It's a contentious area.
"Direct indexing clients usually expect tax-loss harvesting, but there are limitless ways to decide what kind of loss is worth harvesting," the report said. "Is it a drop of 1%, 5%, 10%, or more? Direct indexers tend to run their tax-management algorithm daily but can set any threshold for locking in losses. None of the direct indexers surveyed shared their tax-loss-harvesting secret sauce. Some, like BlackRock's Aperio, though, leave the choice to investors. While it may be tempting to collect every penny of losses, that would entail higher turnover that would likely lead to more tracking error and potential trading impact costs."
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When investors sell losers to harvest losses, they can skew their performance vis-a-vis the benchmark they're following, a phenomenon known as tracking error that arises due to wash-sale rules. Those rules say that an investor has to wait 30 days before or after selling a security to buy the same one back or one "substantially identical" if they want to claim a capital loss.
"Investors need to pay close attention to their direct index's tracking error," Morningstar said. "Even tracking error as small as 2% can vastly change investors' outcomes relative to the index.
