Direct indexing services can mitigate portfolio concentration risk by underweighting exposure in a tax-efficient way. No one wants their investment portfolio to succeed or fail based on the moves of one security. If a single stock makes up 10% or more of an investor’s portfolio, that portfolio can be vulnerable to the moves of that stock. If that company sees a massive drop in value or goes out of business, that portfolio’s value can plummet.
Whatever the reason for the concentrated position, diversification can mitigate concentration risk. But there’s a problem: selling off that position could saddle the portfolio with a big capital gains tax bill. So, this is a situation in which direct indexing can be an ideal solution.
Direct indexing strategies like Vanguard Personalized Indexing help diversify concentrated positions in a tax-effective way. VPI lets advisors customize portfolios to fit their client’s existing holdings and tax needs.
Direct indexing is a separately managed account where the investor owns individual stocks that represent a chosen benchmark index. But unlike a mutual fund or ETF, the investor directly owns each stock in their direct indexing portfolio. This gives the investor tax-loss harvesting opportunities.
Building Portfolios Around Legacy Positions
Direct indexing also lets advisors build target portfolios around clients’ legacy positions. Vanguard offers an example of this. Say a client who works in technology receives company stock. With direct indexing, the advisor can underweight exposure in the portfolio to their company’s stock. In fact, the advisor can also screen out the entire tech sector.
“Vanguard Personalized Indexing allows you to enter a client’s account details and generate a transition analysis that lets you see different scenarios,” according to Vanguard. “You can evaluate the potential tax cost of each scenario and choose the option that works best for your client. Transitioning concentrated positions over time helps minimize the tax obligation while enabling the portfolio to achieve your desired investment exposures.”
Vanguard CEO Tim Buckley said at Exchange 2023 that the company will “be investing heavily” in direct indexing. More information about VPI can be found online.
For more news, information, and analysis, visit the Direct Indexing Channel.
