Direct Indexing and Tax-Efficient Investing: What It Is and How Specialized Advisors Add Value

As tax laws shift and markets fluctuate, high-income professionals are increasingly searching for ways to invest more strategically. For professionals in higher tax brackets, whether that be doctors, dentists, or business owners to name a few, tax-efficient investing isn’t just a benefit—it’s a necessity.

One of the most innovative approaches gaining traction over the last few years is Direct Indexing. But what exactly is it, and how can an advisor who specializes in this area add real value for investors?

Understanding Direct Indexing – Primary Benefits & Considerations

Let’s start with the basic. Direct indexing is a portfolio strategy that replicates the performance of an index—like the S&P 500 or Russell 1000—by purchasing the individual securities that comprise it. Unlike mutual funds or ETFs, where you buy shares of a pooled investment that owns several securities, direct indexing, as the name suggests, gives you direct ownership of the underlying stocks. Think of it like owning your own, custom ETF or index fund, except you actually own the securities outright. Because of this direct ownership, it opens the door to tax optimization opportunities that traditional index funds or ETFs generally do not provide.

The key benefits that direct indexing provide include:

1. Tax-Loss Harvesting: While you can technically harvest losses in ETFs and index funds, you can only do so with shares of the one fund. Since direct indexing allows you to own individual securities, it provides many more options to sell and harvest losses that can offset capital gains elsewhere in their portfolio. This can potentially reduce your overall tax bill year after year.

2. Greater Customization: This strategy also allows you to personalize your strategy and tailor the portfolio to align with personal values (e.g., ESG preferences), exclude specific stocks or sectors, or overweight certain holdings to reflect personal convictions or financial goals.

3. Increased Transparency: You know exactly what you own—down to each individual stock. This level of clarity makes it easier to manage risk, track performance, and integrate with other parts of your financial plan.

4. Enhanced Diversification with Control: While you may not own the same number of securities as an ETF or index fund holds, direct indexing still provides broad market exposure but with the flexibility to adjust holdings as needed. This can be especially helpful in managing concentrated positions.

5. Potential for Long-Term Outperformance via After-Tax Returns: While direct indexing isn’t designed to “beat” the market, the ability to harvest losses and optimize taxes offers the opportunity to improve your after-tax performance over time. This can be particularly helpful for those in high tax brackets.

It is also important to note several other considerations related to direct indexing, such as the potential for additional management costs depending on the platform, required minimums, and the potential for tracking error (i.e., how closely a direct indexed portfolio follows, or deviates from, its benchmark index). All of these considerations are worth understanding and ideally discussing with a dedicated financial advisor that specializes in direct indexing like our team at Tenet.

 

Why Direct Indexing Is Gaining Momentum

For investors in higher tax brackets, the appeal is clear given the ability to proactively manage taxes on an ongoing basis and identify potential tax-efficiencies. Over time, this can meaningfully improve after-tax returns.

In addition to the aforementioned benefits, direct indexing also offers:

• Rebalancing Control: Unlike passive index funds, you can decide how the portfolio is rebalanced or when losses are harvested.
• Efficiency & Access: With the rise of fractional shares and low-cost trading platforms, direct indexing is now more accessible than ever.
• No Unexpected Fund Distributions: For mutual fund holders, especially for actively managed funds, investors may received unexpected (and unwanted) capital gains distributions at year-end, which can provide a tax surprise at year-end that is difficult to both plan for and around. Direct indexing removes this obstacle given that you own and control the individual securities outright.

Who Should Consider Direct Indexing?

While direct indexing can provide benefits to many investors, it is generally most valuable for investors with:

• Taxable investment accounts (rather than IRAs or 401(k)s)
• A long time horizon
• Consistent high-income/earnings and in a high tax bracket
• A desire to align investments with personal values and/or avoid certain industries

It can also be a compelling tool for those planning significant charitable gifts or transitioning ownership of a business. The ability to manage individual stock gains and losses can be useful when preparing for liquidity events or structuring a tax-efficient legacy.

The Role of a Specialized Advisor – How Tenet Wealth Partners Can Help

While the technology behind direct indexing is powerful, maximizing its benefits requires expertise. Advisors who specialize in this strategy, like our team at Tenet Wealth Partners, go beyond just replicating an index.

Our team at Tenet helps clients build and integrate direct index portfolios into a broader wealth strategy that includes:

• Coordinated tax planning across personal, business, and investment accounts
• Proactively monitoring for ongoing tax-loss harvesting opportunities throughout the year
• Navigating wash sale rules and portfolio substitutions
• Aligning the portfolio with estate planning or charitable giving goals

From our perspective, this level of coordination can lead to significant long-term tax savings and better alignment with personal values and goals.

Direct indexing represents a major evolution in how portfolios are built and managed, and this can serve as a more personalized, tax-efficient game-changer for many investors.  If implemented and managed both thoughtfully and properly, and in coordination with broader planning, direct indexing provides the opportunity to significantly enhance long-term after-tax returns and reduce tax drag.

If you’re curious about whether this approach could benefit your portfolio, we invite you to contact us or schedule a meeting to explore the possibilities of tax-efficient investing tailored to your unique needs.