
Ever heard of direct indexing? It’s a strategy gaining popularity among investors looking for more control and tax efficiency in their portfolios. Direct indexing lets you invest in individual stocks that mirror a specific index, like the S&P 500. This means you’re holding similar stocks as the index but with more flexibility and potential tax benefits than traditional funds.
What is direct indexing?
Most investors are familiar with index funds, which bundle securities together into a single investment. Direct indexing uses a different approach. Instead of investing in a pooled fund, investors gain broad market exposure by directly owning individual stocks in a separately managed account (SMA).
Benefits of direct indexing
- Tax efficiency: One of the primary advantages of direct indexing is the potential for tax savings. By owning individual stocks, investors can take advantage of tax-loss harvesting strategies, which can help offset capital gains and reduce their overall tax burden.
- Customization: Unlike ETFs and mutual funds, direct indexing allows investors to tailor their portfolios to specific goals and risk tolerances. This customization can be particularly valuable for investors with unique investment needs or preferences.
- Control: Direct indexing gives investors more control over their investments. They can choose which stocks to include in their portfolio and can adjust their holdings as needed to reflect changing market conditions or personal circumstances.
Tax-loss harvesting
Tax-loss harvesting is a strategy that involves selling investments at a loss to offset capital gains from other investments. By doing so, investors can reduce their taxable income and potentially save on taxes. Direct indexing makes it easier to implement tax-loss harvesting strategies, as investors have more flexibility in choosing the stocks to sell.
How direct indexing works
- Portfolio construction: An investment advisor works with you to create a diversified portfolio of individual stocks that tracks a specific market index. This portfolio is typically held in a separately managed account (SMA).
- Ongoing management: The investment advisor monitors the portfolio and makes adjustments as needed to maintain its alignment with the target index. This includes rebalancing the portfolio to ensure that it remains properly diversified.
- Tax optimization: The investment advisor implements tax-loss harvesting strategies to help minimize your tax liability. This involves identifying stocks that have lost value and selling them to offset capital gains from other investments.
Considerations for direct indexing
- Complexity: Direct indexing requires more trading and active management than traditional index investing.
- Tax implications: The tax benefits of direct indexing can vary depending on individual circumstances. It is important to consult with a tax advisor to understand the potential tax implications.
- Tracking error: Because direct indexing involves customizing a broad market allocation, performance can deviate from the investor’s chosen benchmark returns — often referred to as tracking error. Investors seeking to take advantage of direct indexing’s benefits must be willing to tolerate some carefully managed tracking errors.
Final thoughts
Direct indexing offers a personalized and tax-efficient approach to investing. By owning individual stocks, investors can gain exposure to a broad market index while also benefiting from greater control and tax efficiency.
If you’re looking for a more tailored and tax-efficient investment strategy, contact a Signet advisor to discuss direct indexing.
IMPORTANT DISCLOSURE
This is a publication of Signet Financial Management, LLC.
The information presented is believed to be factual, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Information in this presentation does not involve the rendering of personalized investment advice. It is limited to the dissemination of general information on products and services. A professional adviser should be consulted before implementing any of the options presented.
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