What is direct indexing?

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.

How does personalized indexing work?

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:

• Improved tax efficiency. Personalized indexing provides increased opportunities for tax-loss harvesting (TLH) of individual securities, which can help you capture additional tax alpha for your clients. The technology also allows you to guide clients through tax-effective transitions to personalized indexing.
• Expressing ESG preferences and factor tilts. You can help clients express environmental, social, and governance (ESG) or socially responsible investing (SRI) preferences. You can tilt their portfolios toward stocks with certain characteristics like momentum or value, known as factors.
• Transparency. Because you know exactly what's in the portfolio, you can construct completion portfolios around concentrated positions at the individual security level, while minimizing the tax impact.

Source: Vanguard

Is personalized indexing a new strategy?

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.

Why is TLH so important in personalized indexing?

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.

What if my clients want to customize their portfolios?

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:

• Apply screens to exclude companies that produce tobacco, for example, or have been flagged for human rights abuses.
• Apply tilts to add a preferential weight to the portfolio to maximize certain positive attributes, such as gender diversity or sustainable development.
• Exclude specific companies from the portfolio, either for personal reasons or because of a large, existing holding of a stock. For example, an Apple executive whose portfolio is heavily concentrated in tech stocks could build a personalized index around that concentration.

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.

When is personalized indexing right for my clients?

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:

1. Capturing tax alpha. Clients in a higher federal income tax bracket with taxable accounts and lots of capital gains to offset could benefit from the TLH capabilities of personalized indexing—with the highest benefit coming from daily TLH scanning.
2. Expressing ESG/SRI preferences. If clients have strong ESG or SRI convictions that require an increased level of precision to screen or tilt individual stocks, personalized indexing could be a solution.
3. Applying factor exposures. You can easily tilt a portfolio to incorporate traditional risk factors such as momentum or value. Personalized indexing gives you the control to express specific market views or outlooks for your clients, or to diversify factor exposure around a client's broader portfolio.
4. Diversifying a concentrated position. You can build tax-efficient completion portfolios around large existing stock holdings at the individual security level.

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.

Harness the power of Vanguard Personalized Indexing

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.

5 Source: Cerulli Edge—U.S. Retail Investor, Q3 2021, Environmental, Social, and Governance issue.

Notes:

• Vanguard Personalized Indexing Management, LLC ("Vanguard Personalized Indexing Management"), formerly Just Invest, LLC, an SEC-registered investment adviser, 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. Diversification does not ensure a profit or protect against a loss.
• 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 provides 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 disclosure brochure, please visit the Vanguard Personalized Indexing topic page.