Direct Indexing – Greater Flexibility, Greater Tax Efficiency

CI Radnor Private Wealth - Jun 09, 2022
At Radnor Financial Advisors, we have always included equity index mutual funds or ETFs as a core position in a well-diversified portfolio. These investments provide diversified exposure to stocks in a simple,…
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At Radnor Financial Advisors, we have always included equity index mutual funds or ETFs as a core position in a well-diversified portfolio.  These investments  provide diversified exposure to stocks in a simple, low-cost way.  When you own shares of an index fund or ETF, you have exposure to the stocks in the index indirectly via the commingled vehicle, in the same proportion to the index.

Direct indexing is an investment management solution that allows investors to gain exposure to an index by investing in a representative portion of individual stocks that make up the index, with the goal of matching the performance of the index as closely as possible (i.e., with relatively low tracking error).  While direct indexing has been around for decades, technological advances and the reduction in trading costs have made direct indexing more widely accessible.

So why might direct indexing be a preferred method for gaining broad equity exposure for certain investors?   It enables an investor to construct customized equity portfolios that can be more tax efficient and can be more effectively personalized to meet their values and preferences.

With regard to tax efficiency, if you own a mutual fund or ETF, you own one pooled basket of securities.  If you own a direct indexed separately managed account (SMA), you own all of the underlying securities.  There can be widely different performance among the underlying stocks within an index, even during periods when the overall market is rising.  Certain stocks will rise much higher than the overall market and other stocks may decline.  This provides the opportunity to elect to sell securities with unrealized losses to harvest the losses and/or elect to enact charitable gifting with stocks that have appreciated more substantially than the overall market.

With regard to customization, direct indexing allows for greater flexibility to tailor the underlying investments.  Investors may want a portfolio that expresses specific environmental, social and governance (ESG) preferences.  Or investors might want to emphasize certain factor exposures, such as value or momentum.  Other investors might prefer to avoid certain stocks, sectors or industries (perhaps given concentrated holdings in those areas).

Finally, another unique feature of SMA accounts is the ability to fund with cash, preexisting securities, or a combination of both.  For clients with existing low-basis securities, this provides the ability to transition to an index-like portfolio in a tax efficient manner over time.

Overall, Direct Indexing can be a useful tool for investors.  By owning individual securities in a portfolio directly in a separately managed account, an investor gets broad market exposure similar to mutual funds and ETFs, but potentially with several compelling advantages.

Author

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MICHAEL N. MATTISE

Managing Partner, President,Chief Investment Officer

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