The Basics of Direct Indexing
A common way to measure the performance of the stock market is by looking at market indexes, also referred to as benchmarks. The Dow Jones Industrial Average and the S&P 500 Index are two of the most widely recognized market benchmarks and, if you’re looking to replicate their performance, investing in mutual funds and exchange-traded funds (ETFs) that mimic these indexes might suit your needs.
Alternatively, if you’re seeking direct ownership of the securities that are held in the index, the flexibility to customize holdings and the potential for greater control over tax impacts, you could consider an investment strategy referred to as direct indexing. While this hybrid strategy contains elements of both passive and active investing, it also comes with its own unique risks.
Why Consider Direct Indexing?
Direct indexing offers investors a way to purchase many or all the stocks in a specified index, which can include holding hundreds of individual securities. In the past, this strategy was only available to individuals with over $1 million in liquid assets, often referred to as high net worth investors. However, advancements in technology and the rise of fractional share trading—which allows for the purchase of less than a full share of stock—have made this strategy more accessible to retail investors today.
Some investors might use direct indexing in tandem with tax-loss harvesting, which involves selling stocks that are down in value and using those losses as a way to try to offset capital gains from other positions. (A capital gain—or loss—is the difference between the sale price of your investment and the cost basis.) As stocks are sold, you’ll need to purchase other stocks to maintain the overall balance of your portfolio. Consider consulting with a tax professional to better understand how this strategy can affect your tax situation.
Direct indexing could also be used as a way to customize your investments, tailoring your portfolio to include or exclude specific stocks or sectors that reflect your personal values or investment preferences.
What Are the Risks?
While following an index is typically considered a passive strategy, by making investment decisions such as selling stocks or choosing new stocks to include in the portfolio, you’re intentionally deviating from the index. As such, your returns may be different from the index’s returns and could potentially be markedly lower. You might also incur higher fees following a direct indexing strategy than you would with a typical passive portfolio.
Stock market prices fluctuate. When attempting to tax-loss harvest, a stock you sell might soon rally back above the cost basis; however, you’ll have lost that potential gain as well as altered your portfolio allocation. Working with an investment professional can help you determine the best investment strategy to achieve your individual financial goals.
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