Once a Niche Strategy, Direct Indexing is Now Mainstream
Direct indexing, once considered a niche strategy for high net worth investors, has now become mainstream, with over $1 trillion in assets. The customizable portfolios consisting of individual securities are an increasingly default solution for advisors seeking tax-efficient equity exposure for clients. In addition to index-like performance, they come with the added benefit of systematic tax-loss harvesting — something indexed mutual funds and ETFs can’t provide.
When Isn’t Direct Indexing a Good Fit for a Client?
Most advisor education focuses on the benefits of direct indexing. However, it’s important to consider when this strategy may not be the best fit for a particular client. The following scenarios illustrate when direct indexing may not be the optimal strategy:
Qualified Retirement Accounts
Tax-loss harvesting does not benefit qualified retirement accounts because losses are not deductible. Direct indexing in a qualified account can be wasteful from an asset location perspective and may even create wash-sale risk. However, there are exceptions for investors focused on specific goals like environmental, social, governance investing.
When Outside Capital Gains are Minimal
Clients directing most savings into qualified accounts may not benefit as much from direct indexing compared to those with regular capital gains. Realized losses from direct indexing may not be useful for years to come for clients with minimal outside capital gains.
Clients in Lower Tax Brackets
The case for direct indexing becomes weaker in lower tax brackets, with the benefits of loss harvesting and gain deferral becoming more valuable for clients in higher tax brackets. However, clients in low brackets anticipating sizable future capital gains may still benefit from direct indexing.
When More Appropriate Solutions Exist
Selling an existing tax-efficient investment vehicle to fund a direct indexing account may not always make sense. In cases where the current portfolio has significant embedded gains, a tax-aware long-short strategy may be more suitable. Different scenarios may require different solutions, such as 1031 exchanges for real estate gains.
Advisor’s Fee is Too High
If the manager and advisor’s fee for direct indexing is too high, it can negate the benefits of the strategy. Direct indexing strategies are typically modestly priced, and advisors should consider the overall value compared to the fees involved.
As the use of direct indexing continues to grow, advisors can differentiate themselves by knowing when to apply the strategy and when to consider alternative solutions.
