Direct indexing has a number of arguments in its favor, especially if an investor has a accumulated a certain amount of assets or has some exposures they want to manage. Socially responsible investing is often a key motivator as is tax-loss harvesting. It’s also an attractive option for investors who for whatever reason want to reduce their exposure to a specific stock or sector.
ESG
The controversy around ESG investing is no secret, and reached a fever pitch earlier this year. One concern is that common methodologies can fall victim to greenwashing. In a nutshell, that is when a company “talks the talk” while failing to “walk the walk” when it comes to the sustainability of their practices or products. Direct indexing can allow socially conscious investors to eliminate companies that may make it through traditional ESG screens while still having a negative effect on the world.
It also gives investors who have specific SRI concerns the ability to customize their portfolios a bit more. For example, an investor that is fine with investing in companies involved in the alcoholic beverage and legal marijuana industries may find that some SRI or ESG strategies exclude those companies, reducing the diversification of their portfolio unnecessarily.
Essentially, direct indexing allows investors who are motivated to invest according to their values to fine-tune their exposures accordingly. With many ESG approaches coming under scrutiny, that extra control provided by direct indexing can make it easier for an investor to express their deeply held personal beliefs.
Tax-Loss Harvesting
An investor using direct indexing can rebalance their portfolio in such a way as to minimize the capital gains. They can sell the stocks with the highest cost basis that will incur the smallest tax consequences.
For example, consider an investor who inherits a significant amount of shares representing a particular company. They may want to use an SMA account with the flexibility to accommodate that inheritance. Once a stock is inherited, the heir only faces tax consequences for any appreciation that occurs after the passing of the testator. That means those securities could be moved into the SMA for tax-loss harvesting purposes. They can be used to replace any shares the heir may already own that have a lower cost basis.
However, it should be noted that tax-loss harvesting is not a one-time action. Research from Vanguard indicates that frequent portfolio reviews can improve portfolio reviews can improve investor outcomes. In general, tax-loss harvesting can be great for investors who may have a lot of unrealized capital gains.
Other Direct Indexing Use Cases
But ESG and tax-loss harvesting are not the only uses for direct indexing. There are a variety of other reasons that investors may want to customize their exposure to a particular index. It could be something as simple as having a strong investment conviction. Perhaps the investor wants to rein in exposure to a particular sector or stock that has seen a sharp upward trajectory.
For example, the tech sector saw remarkable returns upward of 30% for three years running starting in 2019. Some investors might have wanted to reduce their exposure to it. That would have served them well when tech stocks crashed in 2022.
Further, working in a particular sector could mean an investor might want to reduce the weighting toward it. This could become even more imperative if they are receiving significant stock options from their employer. In that case, they may want to exclude the company that employs them from their overall index exposure or at least reduce its weight.
The reasons a high-net-worth investor might see value in using direct indexing strategies are myriad. It can serve to support their values, manage their tax consequences or express their views on the market.
Information about Vanguard Personalized Indexing can be found online.
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