What is direct indexing?
May 4, 2023
May 4, 2023
Consumers expect most things to be customized these days, from sneakers to car insurance. You may have noticed that investors are increasingly adopting direct indexing strategies to personalize their investing experiences as well.1 The topic may be generating buzz, but what exactly is direct indexing and how does it work? Which of your clients could potentially benefit from the strategy?
First, let's clarify the name. Financial services providers are using several terms in addition to direct indexing to describe this technology, including personalized indexing and custom indexing. We use the term personalized—and named our product Vanguard Personalized Indexing—because we feel it's the most accurate: Our intuitive software allows advisors to personalize each portfolio to suit their clients' preferences, values, and tax situations.
Picture the way familiar investments like mutual funds or ETFs are constructed. Investors own shares of a basket of securities that seeks to track a given benchmark, such as the S&P 500 or the Russell 3000. By contrast, personalized indexing investors directly own individual stocks in a separately managed account (SMA) that represents a chosen market-capitalization-weighted benchmark. Typically, it's not necessary to own every stock in an index in order approximate its performance.
Because investors have direct ownership of the individual securities in their portfolios, they gain unique opportunities for tax efficiency and personalization that may not be possible with ETFs and mutual funds:
Ultra-high-net-worth investors have been using SMAs for years. In the past, investors had to be able to afford to buy the stocks needed to approximate a given index's performance. Rebalancing the portfolio so it continued to correspond to the index was also difficult and time-consuming for investors and their advisors.
Several relatively recent developments have made personalized indexing accessible to a wider range of investors. Software innovations have automated processes such as regular scanning for TLH opportunities and rebalancing. Most brokerage firms now offer commission-free trades, dramatically reducing transaction costs. Additionally, investors now have the ability to buy fractional shares of stocks, making it more affordable to fund an SMA that models an index.
You likely already use year-end TLH to help improve your clients’ after-tax returns. Personalized indexing opens up many more opportunities for TLH that can help you capture additional tax alpha for them.
Unlike bundled products such as mutual funds or ETFs, personalized indexing allows investors to harvest losses at the security level. Here's how it works: Stocks 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 Because personalized indexing investors have direct ownership of the individual stocks in their portfolios, losses can be captured even in a year when the index gains in value.
For example, the value of the S&P 500 increased 9.76% in the fourth quarter of 2021, yet there were still 133 individual companies that lost value during that time.3 Harvested losses can be used to offset capital gains and then up to $3,000 of ordinary taxable income (as of the 2021 tax year). Losses can also be carried forward to future years.
The frequency that a personalized indexing portfolio is scanned for TLH opportunities—quarterly, monthly, or even daily (as with Vanguard Personalized Indexing)—is key to maximizing investors' tax alpha. Our sophisticated algorithms automatically review each account daily and harvest individual security losses as opportunities arise. Personalized indexing with daily TLH has boosted some investors' after-tax returns by 1%–2% or more.4 For high-net-worth investors, TLH in a personalized index can continue to deliver tax alpha even if the market experiences sustained low volatility.
One problem that can arise with systematically harvesting tax losses is that eventually you will have sold all the losing stocks in the portfolio. Because of the potential capital gains that would result from selling those low-cost-basis stocks, switching to another investing strategy could be costly.
For this reason, personalized indexing with TLH is more effective when there is regular cash flow (to purchase new securities) and when used as a strategy for high-net-worth investors in higher tax brackets, who may have realized gains from other types of investments, such as real estate, private equity, or hedge funds. Other investors may decide not to sell the stocks in their personalized indexes at all but, rather, plan to leave them to charity, since nonprofits don't owe federal income tax on gifts.
Investors increasingly say that expressing ESG or SRI preferences in their investment portfolios is important to them.⁵ Whether they want to support companies with a low-carbon footprint or base their choices on United Nations Sustainable Development Goals, personalized indexing makes it simple for you to align clients’ investments with their values. You can:
Additionally, you or your client may have a conviction in certain risk factors such as value, momentum, or volatility. Personalized indexing can help you manage those factors in addition to any ESG/SRI screens or tilts.
For the right clients, personalized indexing is a powerful tool that can help you solve complex financial problems. However, it's not a good fit for every investor. Let's look at some situations where clients might benefit from this strategy:
Consider how personalized indexing technology might help you differentiate your practice while giving appropriate clients the tax-efficient, customized investing experience they expect. Vanguard Personalized Indexing's sophisticated technology is backed by the trusted portfolio construction and indexing strengths of Vanguard. Our user-friendly software lets you generate custom SMAs in minutes and generate impact and performance reports on demand. We make it simple for you to keep an eye on your clients' personalized portfolios—and to help them understand the progress they're making toward their long-term financial goals.
Request a demo today to explore how Vanguard Personalized Indexing can help deliver additional value to you and your clients.
1 Assets managed with a personalized 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 personalized indexing estimated to reach $1.5 trillion by 2025. Source: Joshua Zwick, and Kamil Kaczmarski, 2021. Competing for Growth. New York, N.Y.: Oliver Wyman, Inc. (2021 edition of the wealth and asset management report with Morgan Stanley.)
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 Source: Vanguard.
4 Source: Kevin Khang, Alan Cummings, Thomas Paradise, and Brennan O'Connor, 2022. Personalized indexing: A portfolio construction plan. Valley Forge, Pa.: The Vanguard Group.
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