Many investors are familiar with mutual funds and exchange-traded funds (ETFs), which may allow them to invest in a pre-selected “basket” of stocks to follow an existing market index. Fewer are aware of an approach called direct indexing, which also seeks to replicate an index’s performance, and could also allow for greater tax efficiency and opportunities for individual customization.
What is direct indexing?
Direct indexing involves owning the individual securities that make up an overall index. With a mutual fund or ETF, you see one investment on your statement. However, a fund may actually hold thousands of individual securities inside the fund wrapping paper; you just don’t see them. With a direct index, you remove the mutual fund wrapping paper and see all the individual stocks in your account. In both examples, the investment strategy is the same – just executed differently.
Why utilize direct indexing as opposed to mutual funds or ETFs?
Customized Tax Strategies:
Direct indexing portfolios involve active tax management strategies with an objective of increasing after-tax returns.
Example: Investors that have capital gains from portfolio activity or other investments and for investors that believe they are in higher tax brackets now, when comparing to their retirement years, would benefit from tax loss harvesting. With a fund, we tax loss harvest when an entire market or index has an unrealized capital loss at a given moment in time. With direct indexing, even when the market as a whole has a positive return, there are often a portion of individual companies with a negative return. Owning all the underlying securities provides more opportunities to take capital losses, even in positive markets, helping you offset current and future capital gains tax.
Legacy Individual Stock Positions:
An investor might own a handful of individual securities with large capital gains, making it difficult to diversify without paying significant taxes. Often times these stocks sit on the sideline with no plan, oversight or management strategy. In a direct index, existing securities can be woven into the overall investment strategy to balance out underweight or overweight sectors to reduce concentration risk.
ESG Investing:
Investors can choose amongst a variety of environmental, socially responsible, and governance screens to construct diversified indexed-based equity portfolios that reflect their values. Mutual Funds and ETFs focused on ESG have their own set of rules that the end-investor may not fully agree with. A direct index allows complete control over which rules and companies to invest in.
| Global Mutual Fund | GSA Direct Index | |
| Investment Strategy | Owns US, International and EM stocks | Owns US, International and EM stocks |
| Customization | One-size fits all. You own the same underlying investments as other investors with the same mutual fund | Varying options for customization that allows for a deviation from the overall index |
| Fee* | Mutual Fund Expense Ratio: Varies – Average GA stock funds: 0.24%. Fee taken inside the fund and reflected in the Net Asset Value | Direct Index Management Fee: 0.18%. Fee taken from portfolio; end investor sees fee |
| Tax Benefit | Limited – can tax loss harvest if the entire market is down. Annual capital gain distributions | Flexible – Provides more opportunity to capture capital losses. No capital gain distributions. Defers taxes to lower income years |
| Investment Minimum | None | Varies from $250K – $600K depending on strategy |
*Fee does not include management fee.
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