July 27, 2022

How to be a tax efficient investor through direct indexing

Direct indexing is a sophisticated investment strategy that involves directly purchasing a limited number of individual equities that represent a major market index rather than purchasing an ETF or mutual fund that mirror the entire index. In the past, transaction costs through fees or commissions have made it difficult and expensive to implement direct indexing but with the rise of zero commission trading it is now much easier to implement with lower cost.

A direct indexing strategy is not designed to try to “beat” the market index but merely to provide similar returns, with similar risks but with additional tax benefits and lower costs to investors.

The main benefits are twofold:

  1. Cost- Lower overall costs by owning the companies directly vs. as part of a larger fund. There is no cost to owning individual companies (assuming a 0-commission arrangement).
  2. Tax Management- Investors receive the benefits of:
  • Control over what is sold/bought and when
  • Additional opportunities for tax loss harvesting (in between stocks vs. in between an entire fund)

It is most important to evaluate the added value that direct indexing provides above and beyond traditional portfolio construction, but at the same time continue to follow the important principles of asset allocation and diversification.

Generally, for a portfolio to be considered diversified, a minimum of 25 similar investments would need to be included. Using US large cap stocks as an example, a common investment to provide diversification would be investing in an S&P 500 index fund. Although this would give an investor exposure to 500 of the largest stocks in the US stock market, direct indexing would handpick 25-100 of these individual companies that closely mirror and correlate to the index and purchase their shares. This gives advisors and investors autonomy over their portfolios as they are no longer reliant on fund managers to make prudent investment decisions on their behalf.

When investing in an ETF or mutual fund, there is an underlying “soft cost” that is paid to the fund company in exchange for the management of their fund. Although ETFs generally have lower costs than mutual funds, the industry average for underlying expenses is 0.65%  across a diversified portfolio. These costs are generally assessed on top of an advisory fee that is being paid to the financial advisor. Since direct indexing involves independent construction of an index through owning a number of individual investments, there are no “soft” costs paid to the company.  Investment managers or advisory firms will charge a smaller additional fee for their direct indexing programs. It is important to note that soft costs in a fund are fixed, and do not decrease as asset levels increase. The cost of direct indexing is typically scaled (meaning, fee percentages drop as assets increase), which generally adds up to significant fees savings the investor versus investing in ETFs or mutual funds.

ETF or mutual fund managers sell investment within their respective funds that can result in a capital gains or losses. When gains are realized, they are often passed through to the investors that own these funds regardless of their personal tax situation. These gains and taxes are out of the investors control and are realized solely at the discretion of the fund manager. In direct indexing, there is total control and autonomy over when individual stocks are bought and sold.  This can provide significant benefit when coordinating entire tax pictures including Roth conversions, Medicare surcharges and more. Industry studies have shown that controlling the “turnover” in a portfolio can lead to an average of a 1% alpha per year in returns.

The most significant benefit of direct indexing is the increased tax alpha on a portfolio through tax loss harvesting. Tax loss harvesting is a strategy that intentionally realizes a loss in a portfolio to offset a gain elsewhere. Generally, when the fund is sold at a loss, money is reinvested into a similar fund to avoid a wash sale. An over simplified example would be that if Coca Cola declined by 20%, that stock could be sold to lock in losses, and Pepsi could be purchased. This would assuming something happened in the beverage/cola industry and a similar stock, like Pepsi, also declined.

Losses can be used to offset future gains or income. If $50,000 of long-term losses were realized by an investor through tax loss harvesting in a year, this can be utilized in 2 ways:

  1. A maximum of $3,000 can be used each year to offset income.
  2. An unlimited amount of losses can be used to offset long term realized gains.

In this example, if $3,000 was used to offset income and $30,000 was used to offset long term gains, the excess of $17,000 could be carried over to the next year and used the same way each year moving forward.

Tax loss harvesting with ETFs or mutual funds is dependent on the entire fund or index operating at a loss, rather than being able to utilize a loss on one single company. With direct indexing, one company could be sold, without selling an entire fund or ETF. The chart below shows returns from the Russell 3000 (index that tracks US small cap stocks) from 2006-2021:

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Using 2021 as an example, the index as a whole finished positive 25.7% for the year. However, of the 3,000 stocks that make up the index, 992 of those stocks had a negative return year. With direct indexing, those companies that are operating at a loss can be sold to capture the loss, even though the index has a positive return for the year.

A 2020 study published by the Financial Analysts Journal found that from 1926-2018, an investor using direct indexing in a portfolio with 500 of the biggest stocks in the US stock market would have improved their after-tax returns by 1.08% per year compared to a portfolio that did was tax loss harvested. At first glance this may seem like a small figure but compounded over many years makes a significant impact.

At EWA, we are excited to now offer direct indexing to our clients to have total autonomy over moves in their non-qualified accounts and take advantage of the many tax benefits.


Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.

Stock markets are volatile, and the prices of equity securities fluctuate based on changes in a company’s financial condition and overall market and economic conditions. Although common stocks have historically generated higher average total returns than fixed-income securities over the long-term, common stocks also have experienced significantly more volatility in those returns and, in certain periods, have significantly underperformed relative to fixed-income securities. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by the Fund. A common stock may also decline due to factors which affect a particular industry or industries, such as labor shortages or increased production costs and competitive conditions within an industry.  For dividend-paying stocks, dividends are not guaranteed and may decrease without notice.

Past performance is no guarantee of future results.  The change in investment value reflects the appreciation or depreciation due to price changes, plus any distributions and income earned during the report period, less any transaction costs, sales charges, or fees. Gain/loss and holding period information may not reflect adjustments required for tax reporting purposes. You should verify such information when calculating reportable gain or loss.

This content has been prepared for general information purposes only and is intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an offer, invitation, investment advice or inducement to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any matter contained in this document.  The tax and estate planning information provided is general in nature.  It is provided for informational purposes only and should not be construed as legal or tax advice.  Always consult an attorney or tax professional regarding your specific legal or tax situation.

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Important Disclosures:

Securities and advisory services offered through EWA LLC dba Equilibrium Wealth Advisors (a SEC Registered Investment Advisor).
* Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.  However, the value of fund shares is not guaranteed and will fluctuate.
* Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity, and redemption features.
* The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. You cannot invest directly in this index.
* All indexes referenced are unmanaged. The volatility of indexes could be materially different from that of a client’s portfolio. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. You cannot invest directly in an index.
* The Dow Jones Global ex-U.S. Index covers approximately 95% of the market capitalization of the 45 developed and emerging countries included in the Index.
* The 10-year Treasury Note represents debt owed by the United States Treasury to the public. Since the U.S. Government is seen as a risk-free borrower, investors use the 10-year Treasury Note as a benchmark for the long-term bond market.
* Gold represents the afternoon gold price as reported by the London Bullion Market Association. The gold price is set twice daily by the London Gold Fixing Company at 10:30 and 15:00 and is expressed in U.S. dollars per fine troy ounce.
* The Bloomberg Commodity Index is designed to be a highly liquid and diversified benchmark for the commodity futures market. The Index is composed of futures contracts on 19 physical commodities and was launched on July 14, 1998.
* The DJ Equity All REIT Total Return Index measures the total return performance of the equity subcategory of the Real Estate Investment Trust (REIT) industry as calculated by Dow Jones.
* The Dow Jones Industrial Average (DJIA), commonly known as “The Dow,” is an index representing 30 stock of companies maintained and reviewed by the editors of The Wall Street Journal.
* The NASDAQ Composite is an unmanaged index of securities traded on the NASDAQ system.
* International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
* Yahoo! Finance is the source for any reference to the performance of an index between two specific periods.
* The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage is often obtainable in commodity trading and can work against you as well as for you.  The use of leverage can lead to large losses as well as gains.
* Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
* Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
* Past performance does not guarantee future results. Investing involves risk, including loss of principal.
* The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee it is accurate or complete.
* There is no guarantee a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
* Asset allocation does not ensure a profit or protect against a loss.
* Consult your financial professional before making any investment decision.

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