When is direct indexing right for your clients?

Direct indexing (also known as personalized or custom indexing) can help you solve some of your clients' most complex financial challenges—but the strategy isn't a good fit for every investor. How can you decide which of your clients and prospects might benefit?

Remember, a direct indexing portfolio is a separately managed account (SMA) based on a benchmark index. Because investors have direct ownership of the individual stocks in their portfolios, they gain opportunities for tax efficiency and personalization that may not be possible with ETFs and mutual funds.

Explore use cases for direct indexing

Consider these four primary use cases where a direct indexing strategy like Vanguard Personalized Indexing could add real value for your clients.

Tax-loss harvesting

Clients directly own the stocks in their direct indexing portfolios. This enables you to sell individual securities in the portfolio at a loss, even in years when the benchmark index's return is positive. Harvesting tax losses in this way can help offset your clients' capital gains at tax time—and help increase their after-tax returns.

S&P 500 return versus % of stocks with positive and negative returns

Source: FactSet, as of December 31, 2023.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Vanguard Personalized Indexing automatically scans portfolios each day for tax-loss harvesting and rebalancing opportunities, helping you:

• Optimize short- and long-term holding periods.
• Offset capital gains and losses.

Which clients might benefit meaningfully from the daily, security-level tax-loss harvesting offered by Vanguard Personalized Indexing? Consider high-net-worth clients who:

• Have large enough capital gains regularly arising from assets held outside of their taxable equity accounts. Look for realized capital gains on the order of at least 3% to 4% of taxable equity holdings per year.
• Have a meaningful share of wealth invested in their taxable equity accounts. Look for clients with at least 20% to 30% of their financial wealth in taxable equities.

For your high-net-worth clients with significant capital gains, daily tax-loss harvesting with Vanguard Personalized Indexing can make a meaningful difference—roughly doubling the amount of harvested losses they generate.* For lower-net-worth investors, the tax efficiency of direct indexing may not outweigh the additional cost and complexity.

Expressing environmental, social, and governance (ESG) preferences

Some of your clients might feel passionate about seeing their personal preferences reflected in their investments and have very specific criteria for personalization that can't be met with off-the-shelf ETFs and mutual funds. Using Vanguard Personalized Indexing, you can tailor portfolios for these clients to precisely reflect their choices:

• Screen out specific companies, sectors, or industries from a client's portfolio entirely, such as companies that manufacture nuclear weapons or engage in animal testing.
• Tilt the portfolio to improve its focus on topics that are important to a client, such as weighting the portfolio with companies that are moving toward a lower carbon footprint.

As you customize portfolios for these ESG-oriented clients, make sure they're comfortable with the slight fee premium of direct indexing over an index ESG fund, as well as the potential additional tracking error that could result.

Factor investing

Do you have clients who use (or want to use) factors as part of their investment strategy? For investors who want to overweight their portfolios toward companies with certain characteristics (factors) such as value or momentum, prepackaged ETFs can often be a good option. However, some clients may have customization needs that prohibit using off-the-shelf ETFs. In those cases, direct indexing could be the solution you need.

For example, a client may want to use a combination of factors or to apply those factors in a way that doesn't already exist as a prepackaged solution. You'll need to determine whether the added cost, complexity, and tracking error of factor investing with direct indexing outweighs the potential benefits, such as the satisfaction of holding a customized portfolio and the potential for alpha above that of an index fund.

Large existing positions and positions with large embedded capital gains

Say a new client's portfolio has a concentrated position, or a large amount of highly appreciated stock. Vanguard Personalized Indexing can serve as a tax-efficient way to transition to a diversified portfolio. As your client's concentrated position is gradually sold into a more diversified direct indexing portfolio, harvested losses can be used to offset capital gains generated by those sales.

Diversify large existing stock holdings, minimize taxes

Some clients may not be able to sell a concentrated position, for example, if they have an ESOP holding of employer stock or unvested company stock with restrictions on insider selling. You can use Vanguard Personalized Indexing to work around a concentrated position and diversify your clients' holdings, safeguarding them from a downturn in their company or industry.

For example, for an Amazon executive whose portfolio is heavily concentrated in tech stocks, you could build a direct index around that concentration, either excluding Amazon stock specifically or as part of the broader allocation to the tech sector.

Assess your clients' needs

Ask yourself the following questions to help decide whether a current or potential client might benefit from the customization and tax-loss harvesting capabilities of Vanguard Personalized Indexing:

• Does the potential tax alpha of direct indexing outweigh the extra cost for my client?
• Does my client have specific exposure needs (ESG or other) that can't be met by pooled products?
• Does my client have a large existing position that they cannot sell because of restrictions or the tax impact? Would it be more beneficial to complete a portfolio around that position or to slowly transition out of it?
• Does my client have the ability to sustain any unintended tracking error relative to the starting investment universe?

How you weigh the trade-offs between mutual funds, ETFs, and direct indexing will depend on your clients' goals and risk tolerance.