Direct indexing is an actively managed and tracked investment strategy that involves replicating the performance of a chosen index through a customized purchase of individual stocks of that index. This strategy allows an investor to have investments that have similar characteristics to the index with the added potential benefits of tax loss harvesting.
The traditional way to invest in the stock market is through a mutual fund or exchange-traded fund (ETF). These funds hold a diverse range of stocks, bonds, and other assets, and are most often selected based on the merit of their historical performance and yield. While these types of funds offer diversification and professional management, they also come with several drawbacks regarding control and taxes.
While investors do have the ability to sell a mutual fund or ETF at their discretion, they lack the ability to influence the selection and purchase of individual stocks that make up the fund as this is the sole responsibility of the fund manager. In contrast, direct indexing allows an investor to gain exposure to specific stocks within an index they want to include in their portfolio, and adjust the allocation of their assets to suit their personal investment objectives.
One of the key advantages of direct indexing is the ability to help investors save on taxes. When investors participate within a traditional fund, capital gains taxes are passed on to the fund’s shareholders, who must pay them even if they haven’t sold any of their shares in the fund. In contrast, with direct indexing, investors can use a technique called tax-loss harvesting to offset capital gains through realized losses on specific equities, potentially reducing their tax bill.
Despite its advantages, direct indexing is not without its challenges. Building and managing a portfolio of individual stocks can be time-consuming and require a significant amount of expertise. Customizing the portfolio or tax-loss harvesting can also lead to tracking errors, which may be undesirable for investors seeking to replicate the performance of the index.
At Instrumental Wealth, we both know and understand the complexities of managing a direct index investment strategy and will work with you to build one that meets your financial objectives.
Instrumental Wealth | Direct Indexing