Hello, and welcome to another edition of Wealth Management Insights. I’m Steve Edwards, Head of Portfolio Construction and Cross-Asset Strategy at Morgan Stanley Wealth Management. I’d like to talk about direct indexing today—what it is, how it works, and what we see as its key advantages.
Generally speaking, tracking the performance of a market index, like the S&P 500, is a common investing strategy. While these indices themselves are not investable, there are various index-tracking mutual funds and ETFs that many investors utilize to get passive exposure to the benchmarks.
But fewer investors may be familiar with an approach called direct indexing, which also aims to replicate an index but could allow for tax advantages and customization. In a nutshell, direct indexing means you're buying the individual stocks that make up a reference index—or, owning them directly, as the name suggests—instead of buying a basket of stocks.
Managers can implement this strategy through separately managed accounts, a structure that allows for security-level purchases and sales. To start, managers typically run an optimization process to figure out an appropriate sampling of equities to track the chosen index and buy those shares to establish an initial portfolio. Over time, they monitor and update those positions periodically and rebalance in order to achieve investor goals.
But why would an investor consider direct indexing, instead of just buying a mutual fund or an ETF? Let’s talk about two major potential benefits of direct indexing, starting with customization.
On this front, first of all, investors can choose their preferred reference index. Usually, that’s driven by a strategy’s place in an overall asset allocation. For example, investors seeking large-cap US equity exposure could choose the S&P 500 as their index to replicate. Or, if they’re seeking international stocks, they could pick the MSCI EAFE Index as their reference.
Beyond choosing the index, investors can take customization to the sector or security level, based on their personal goals or values. For instance, an investor might wish to avoid companies with high levels of carbon emission, while featuring stocks with more favorable environmental impacts.
The second key benefit of direct indexing is tax efficiency. Arguably, direct indexing’s most quantifiable potential advantage comes through tax-loss harvesting. This involves selling investments at a loss and using those losses to offset realized gains, or potential future gains, ultimately reducing an investor’s tax liability. It’s worth noting that tax-loss harvesting can be especially effective for asset classes that are considered more efficient, such as large-cap growth equities, where it has typically proven to be more difficult for active managers to outperform the index.
Now, while direct indexing does feature some attractive potential benefits, the strategy also faces limitations. For one, it may struggle with buying and selling securities that are less liquid. Also, direct indexing typically requires a minimum investment of $250,000 and may lead to higher management fees than an investment in similar ETF strategies.
Let’s wrap up with a quick overview of some historical and hypothetical simulations we ran, which we used to evaluate the ability of direct indexing to deliver favorable after-tax returns relative to passive ETFs and active strategies. Here’s what we found:
Compared to index-tracking ETFs, direct indexing strategies tended to deliver greater after-tax returns, and they did so with a high probability of success.
And when compared with active strategies, direct indexing tended to do better in more efficient asset classes, over shorter investment horizons, and assuming higher levels of income for taxable investors. This was due to higher tax rates and more favorable tax-loss harvesting opportunities.
We believe that these attributes of direct indexing, when viewed through the appropriate lens, suggest that the strategy may make sense for investors with taxable accounts.
There’s more you can read on this subject, including our recently published report called “Direct Indexing: Opportunities for Customization and Potential Tax Alpha.” For a copy of the full report, or to learn more about employing direct indexing in your portfolio, please reach out to a Morgan Stanley Financial Advisor. Thank you for listening.
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S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.
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Hypothetical Performance
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Hypothetical performance results have inherent limitations. The performance shown here is simulated performance not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results.
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