Direct Indexing
Are you planning a sale of your business or a highly appreciated investment? Are you expecting a hefty tax bill due to capital gains as a result? If so, direct indexing may be a tool worth considering.
The proliferation of index funds has enabled everyday people to have highly diversified investment portfolios at a very low cost. Consider the S&P 500 for example, which is an index that represents the performance of the 500 largest U.S. companies. An investor could purchase a single ETF that tracks the performance of the S&P 500 index at a cost of just 0.03%.1 Alternatively, an investor could purchase shares of all 500 of the constituent companies according to their weight in the index (or a representative sample) and expect to achieve roughly the same performance. This latter option is called direct indexing. Today, there are many providers that buy and sell stocks on behalf of investors to provide direct indexing strategies on a turnkey basis.
Why would someone want to own hundreds of individual stocks, instead of just one diversified ETF? One reason investors might consider direct indexing is for the benefits of enhanced tax loss harvesting compared to owning a single fund. If someone owned an S&P 500 index fund in 2024, it returned approximately 25%. Even though 30% of the constituent companies in the index lost value in 2024, the winners outgained the losers such that the weighted average return of the index was 25%. There was virtually no opportunity for tax loss harvesting for owners of index funds in such a positive market. However, if someone invested in the S&P 500 using direct indexing, there were significant opportunities for tax loss harvesting. In 2024, 30% of the S&P 500 companies lost value for the year. Within those twelve months, 51% of the S&P 500 companies experienced a drawdown of at least 20%, and 95% of the companies had at least a 10% drawdown.
When a stock declines in value below its original purchase price, it could be sold at a loss (realizing the loss for tax purposes) and the proceeds could be reinvested in another stock, perhaps in the same industry. When hundreds of stocks are held within an account, the capital losses from those declining stocks could be realized and subsequently used to offset capital gains from another sources, helping reduce the overall tax liability for the year. Even with this tax loss harvesting activity, the portfolio could still track the performance of the index fairly closely.
It is important to remember that capital gains are not the worst thing in the world. After all, a capital gain means that the investment appreciated in value, which is a good thing. However, direct indexing, with a focus on realizing capital losses as they become available, may be a useful tool to reduce the tax liability of inevitable capital gains.
If you have any questions about direct indexing or want to know if it could be a helpful tool in your situation, just give us a call. We’re always happy to discuss.
Net expense ratio of Vanguard 500 Index Fund ETF (VOO)
