How to set up a direct indexing portfolio

This article was updated October 20, 2022.

You've probably gotten a number of questions from your clients about direct indexing, also known as personalized or custom indexing, and its potential benefits. Interest in direct indexing is certainly on the rise. Assets managed with a direct indexing strategy grew more than threefold between 2015 and 2021, from $100 billion to roughly $350 billion—a pace that is expected to accelerate, with total assets managed with direct indexing estimated to reach $1.5 trillion by 2025.¹

But the rising adoption of personalized direct indexing by mass-affluent and high-net-worth investors, and the sheer number of direct indexing options available in today's marketplace, raise many questions. Recent Vanguard research addresses two critical questions about using a direct indexing strategy: 

• What's the difference between similar direct indexing implementations, including tax-loss harvesting (TLH) frequency?
• How can you help your clients incorporate direct indexing into their portfolios, and how much personalization can they pursue without potentially lowering their expected returns?

The impact of tax-loss harvesting

Direct indexing strategies use tax-loss harvesting to help investors potentially earn better returns. Rather than owning a pooled product like an ETF or a mutual fund, investors own individual stocks that represent an index, such as the CRSP US Total Market Index, in separately managed accounts (SMAs).

Direct indexing software scans the portfolio for TLH opportunities at a set frequency, such as quarterly or monthly. Securities that drop below their cost basis are sold, and correlated (but not "substantially identical") replacement stocks are immediately repurchased to navigate the wash-sale rule.² This way, investors may capture the gains of the chosen index while harvesting losses that can offset capital gains at tax time.

Direct indexing made simple

Request a demo today to discover how Vanguard Personalized Indexing can help deliver additional value to you and your clients.

Tax-loss harvesting frequency matters

A key difference between direct indexing implementations is how often they scan for tax-loss harvesting opportunities, ranging from once a year to daily. Our research found that more frequent scans lead to materially higher and more consistent loss harvesting. The differences in TLH alpha can be wide, ranging from 20 basis points (bps) to well over 100 bps for a prime PI investor with extensive recurring capital gains.³ Direct indexing with daily tax-loss harvesting is critical to achieving the maximum harvest in “typical” (non-high) volatility environments.

Average 10-year TLH alpha by harvest frequency
(Ultra-high-net-worth investor)*

*Assumes quarterly contributions.

Source: Kevin Khang, Alan Cummings, Thomas Paradise, and Brennan O’Connor, 2022. Personalized indexing: A portfolio construction plan. Valley Forge, Pa.: The Vanguard Group.

The figure shows the average 10-year TLH alpha for each mode for UHNW investors. For UHNW investors with unlimited loss-offsetting income, TLH alpha rises from 1.64% for "direct indexing annually" to 3.10 % for "direct indexing daily"—a significant difference of 1.46%.

Building direct indexing portfolios

A direct indexing portfolio is an SMA based on a chosen market-capitalization-weighted benchmark. Investors can personalize their accounts to incorporate desired factors; tilts; and environmental, social, and governance (ESG) preferences or to account for concentrated positions.

A direct indexing portfolio is flexible, but such "active" customizations typically run a tracking error between 75 and 275 bps, with 75 bps representing the minimum level of tracking error that can result from TLH using individual securities and navigating the wash-sale rule. Additional personalization for ESG and/or factors can cause tracking error to rise to 275 bps.⁴

How much tracking error is too much?

As our research points out, recommendations for how much personalization investors can pursue without sacrificing performance vary sharply by investor profile and direct indexing alpha potential (a highly predictable quantity based on the investor's capital gains profile). Investors with an expected direct indexing alpha of 150 bps or more can largely replace their existing passive U.S. equity allocation with PI and personalize it freely,⁵ that is, up to 275 bps of tracking error, without having to change their overall asset allocation.

For investors with an expected direct indexing alpha below 150 bps, however, personalization in direct indexing may come at a cost. First, greater tracking error in direct indexing calls for a lower allocation to equity and therefore a lower expected return from the entire portfolio. Second, as tracking error rises above 75 bps and the optimal equity allocation declines, the optimal mix between direct indexing and passive may also change. Investors may want to lower their overall equity allocation to accommodate meaningful personalization in the direct indexing portfolio.

Explore Vanguard Personalized Indexing

If you have clients who could benefit from the tax optimization and customization features of direct indexing, consider Vanguard Personalized Indexing (VPI). VPI's algorithms automatically review each of your clients' accounts daily and harvest individual security losses as opportunities arise—helping you to potentially minimize taxes and maximize long-term portfolio growth for your clients. You can also provide your clients with a truly personalized investing experience that reflects their specific values and financial objectives. VPI lets you build custom SMAs in minutes that incorporate ESG preferences, factors, and tilts and address clients' asset allocation needs. Request a demo to get more information on Vanguard Personalized Indexing.

1 Morgan Stanley and Oliver Wyman, Inc., 2021. Wealth & Asset Management: Competing for Growth.

2 The IRS doesn't allow an investor to sell an investment at a loss and then immediately repurchase it (known as a "wash sale") and still claim the loss. If the investor buys the same investment or any investment the IRS considers "substantially identical" within 30 days before or after the investor sells it at a loss, the loss will be disallowed. If you need guidance on whether an investment would be considered substantially identical, consult a tax advisor. 

3 Kevin Khang, Alan Cummings, Thomas Paradise, and Brennan O'Connor, 2022. Personalized indexing: A portfolio construction plan. Valley Forge, Pa.: The Vanguard Group. Simulation as of September 2021.

4 Typical PI portfolios have a tracking error well below 275 bps, but it may rise above this level in some cases. One notable source of a high tracking error level is completion portfolios, in which a PI portfolio is built around the securities that account for a significant percentage of the benchmark (for example, excluding Meta [formerly Facebook], Amazon.com, Apple, Netflix, and Alphabet [parent of Google]).

5 Assumes that all asset allocation takes place in taxable accounts. The practical implications are applicable as long as the investor has a current allocation to taxable equity, which is extremely common for suitable PI investors.

Notes:

• Vanguard Personalized Indexing Management, LLC (“Vanguard Personalized Indexing Management”), formerly Just Invest, LLC, an SEC-registered investment advisor is an independently operated wholly-owned subsidiary of The Vanguard Group, Inc. (“Vanguard”). Vanguard Personalized Indexing is an asset management technology that has been developed and is offered solely by Vanguard Personalized Indexing Management.
• All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
• ESG portfolios are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the data provider for ESG criteria generally will underperform the market as a whole or, in the aggregate, will trail returns of other portfolios screened for ESG criteria. The data provider’s assessment of a company, based on the company’s level of involvement in a particular industry or the data provider’s own ESG criteria, may differ from that of other portfolios or of the advisor’s or an investor’s assessment of such company. As a result, the companies deemed eligible by the data provider may not reflect the beliefs and values of any particular investor and certain screens may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the customized investment strategy will depend on the data provider’s proper identification and analysis of ESG data.
• Factor investing is subject to investment style risk, which is the chance that returns from the types of stocks selected will trail returns from U.S. stock markets. Factor investing is subject to the risk that poor security selection will cause underperformance relative to benchmarks or funds with a similar investment objective.
• The information contained herein does not constitute tax advice, and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code. Each person should consult an independent tax advisor about their individual situation before investing in any security.
• Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications. Prospective investors should consult with their tax or legal advisor prior to engaging in any tax-loss harvesting strategy. Neither Vanguard Personalized Indexing Management nor Vanguard provide tax or legal advice.
• For more information on Vanguard Personalized Indexing Management and Vanguard Personalized Indexing, and to access Vanguard Personalized Indexing Management's Form CRS and Form ADV Part 2A and disclosure brochure, please visit the Vanguard Personalized Indexing topic page.