Morgan Stanley
  • Wealth Management
  • Oct 3, 2023

How Direct Indexing Can Offer Investors Potential Tax Savings and Flexibility

Learn more about the potential advantages of a direct indexing strategy and how it can help you meet your financial goals.

Many investors are familiar with mutual funds and exchange-traded funds (ETFs), which allow them to invest in a pre-selected “basket” of stocks, often to follow an existing market index. But fewer are aware of an approach called direct indexing, which also seeks to replicate an index’s performance but could also allow for greater tax efficiency and opportunities for individual customization. 

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Whether you are building a new portfolio or making changes to your current investments, direct indexing may be worth considering. Let’s take a closer look at how it works, as well as the potential benefits and drawbacks.

What Is Direct Indexing?

In a nutshell, direct indexing seeks to replicate an existing stock index, such as the S&P 500 or the Russell 3000, in a taxable account. Through a separately managed account, an investment manager establishes direct ownership of individual stocks that make up the chosen index. Using optimization software, the manager typically includes a sample of the index constituents, which allows for close mirroring of the index’s performance.

So, why not simply invest in a mutual fund or ETF that passively tracks your index of choice? With direct indexing, you have access to potential tax savings not typically possible when you own an index-tracking fund. You also tend to have more flexibility when it comes to the individual stocks you choose to own.

With direct indexing, you can tailor your portfolio to your values and goals.

Helping Reduce the Impact of Taxes

Perhaps the biggest potential benefit of direct indexing comes from the ability to use a strategy called tax-loss harvesting. This involves selling positions that are down—“harvesting” or recognizing the losses—and using those losses to offset capital gains from other positions, including those from other asset classes or managers. This strategy may help lower your tax bill.  Some direct indexing strategies or platforms may offer systemic solutions to automatically and opportunistically harvest tax losses year round.

Tax-loss harvesting typically isn’t an option with an index-tracking fund because you own interests in the fund, instead of the individual securities.

Even if you haven’t realized capital gains in a given year, you may still use up to $3,000 in realized losses to offset your ordinary income. Additionally, any leftover capital losses can be carried forward to future years. As your investments potentially grow over time, these incremental tax savings can add up in a big way.

To test the potential tax benefits an investor could gain with direct indexing with systematic, year-round tax-loss harvesting, we conducted a series of simulations that compared the strategy1 with passive ETFs and active investment strategies. Our research found:

  • Compared to index-tracking ETFs, in both historical and forward-looking testing, the direct indexing strategies with systematic, year-round tax-loss harvesting were more likely to deliver greater after-tax returns.
  • Direct indexing also tended to perform better than active strategies in certain asset classes, such as U.S. large-cap core equities, over shorter time horizons and with higher-income investors.

Investing for Your Goals and Values

Another potential benefit of direct indexing that you won’t find with a typical index fund is the ability to customize your portfolio’s holdings. Index ETFs are essentially a package deal—you get every stock that’s part of the index. But with direct indexing, you can tailor your holdings to align more closely with your financial goals or personal values.

For example, if you’re an environmentally conscious investor, direct indexing may allow you to avoid certain companies with high carbon emissions. Or perhaps you feel you have too much exposure to a certain stock or sector that you view as risky; direct indexing can help you diversify around that position to help mitigate the risk.

You can make adjustments as you see fit with help from a Financial Advisor who will monitor, periodically update and rebalance your investments so they don’t stray far from performance targets.

Is Direct Investing Right for You?

As with most investment strategies, there are limitations to consider before you dive into direct indexing. For example, the strategy may lead to higher management fees than investing in similar ETF strategies, because the level of customization may involve buying and selling securities that can lead to higher transaction costs. However, depending on your individual portfolio, the potential tax savings from harvesting losses may help to offset those costs.

In addition, when owning individual securities, direct indexing typically requires a relatively high minimum investment of $250,000. As such, if you’re interested in direct indexing but have assets held across multiple accounts at different institutions, you may need to consolidate your investments with a single Financial Advisor to realize the full potential of this strategy.

Direct indexing can be beneficial, but it typically requires a disciplined approach. Ask your Morgan Stanley Financial Advisor if the strategy may be right for you. Your Financial Advisor or Private Wealth Advisor has access to Morgan Stanley’s Total Tax 365 solutions that may help you implement a direct indexing strategy that’s tailored to your unique goals and needs.

You can learn more by listening to my brief audiocast or by requesting a  copy of Direct Indexing: Opportunities for Customization and Potential Tax Alpha.

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