Direct Indexing for Tax Efficiency in Concentrated Stock Portfolios
In the world of investment strategies and products, direct indexing may be one you’re not familiar with quite yet—but you’re likely to see more of it in the near future. According to Cerulli Associates, direct indexing is expected to grow faster than other popular investment products over the next five years including ETFs, mutual funds, and separately managed accounts (SMAs). [1]
In terms of tax-efficient investing strategies, direct indexing is worth consideration for those high-net-worth investors and their advisors who are particularly tax-sensitive and value the ability to customize their investment line-up.
Wealth Advisors of Tampa Bay has utilized direct indexing through our institutional partners for many years, and in June 2024, we introduced our own proprietary product that brought this innovative solution directly to our clients. [2,3]
Let’s take a look at what, exactly, direct indexing is and how we’ve been able to leverage its advantages to support our clients’ investment goals.
What Is Direct Indexing?
Direct indexing refers to the strategy of replicating an index by purchasing shares of the stocks within that particular index. If you’re familiar with ETFs or mutual funds, they have a similar premise. However, with ETFs and mutual funds, investors hold a share of the investment product itself (the fund), not the underlying securities. In fact, investors don’t have a say in what underlying securities are bought, held, or sold within the fund.
Direct indexing enables investors to hold shares in the underlying securities themselves—meaning you’re able to customize what’s included. With other funds, a certain stock can be included simply because it’s in the index—whether it provides value to the fund or not is often irrelevant.
Direct Indexing vs. Custom Indexing
Direct indexing and custom indexing are similar, as they both provide opportunities for investors to own individual securities and reap the potential benefits of tax-saving strategies like tax-loss harvesting.
Remember, direct indexing allows investors to own the individual securities within an index, enabling investors and their advisors to tweak the portfolio to better align with their individual tax situations and investment goals.
Custom indexing, however, enables investors to build a personalized index from the ground up. Custom indexing allows you to select securities based on specific criteria such as ethical considerations, industry preferences, or specific financial objectives. For example, if you’re particularly interested in ESG investing, you may come up with parameters that only incorporate companies with carbon-neutral goals or environmentally focused mission statements.
While both methods provide flexibility and potential tax benefits, the choice between custom and direct indexing will depend on what you want to achieve with your investments, how hands-on you want with portfolio design, and your particular tax considerations. Understanding these differences is crucial in picking the strategy that best aligns with your financial goals.
The Benefits of Direct Indexing
Direct indexing offers a few key benefits for investors looking to implement tax-efficient investing strategies. These include:
Mitigate risks in inherited and concentrated stock positions: Direct indexing is an effective tool for reducing risks over time, particularly with inherited stock (which comes with a step-up in cost basis) and reducing overconcentration.
Support your estate planning strategy: Because you can select which individual shares of stock to leave your heirs, you can identify those that have significantly appreciated over time. When the assets are transferred to your beneficiaries after death, they’ll receive a step-up in cost basis. This can help significantly reduce the tax liability when your loved ones eventually decide to sell the stock.
Enhance tax efficiency through tax alpha: The term “tax alpha” refers to your portfolio’s tax liability as it compares to the benchmark index. If your portfolio is able to reduce its tax liability beyond the benchmark you’re following, this excess amount is considered tax alpha. Because direct indexing enables investors and their advisors to leverage tax-loss harvesting throughout the year, they can aim to optimize their tax situation by selectively realizing losses. According to a five-year backtest by Smartleaf, direct indexing can add up to 1.93% in tax alpha to a portfolio each year, outperforming traditional ETFs. [4]
Customize to Specific Indices and Exclusion Options: Direct indexing provides unparalleled flexibility to customize strategies to specific indices such as the S&P 500, NASDAQ, MSCI, or proprietary models. It also allows for the exclusion of specific securities or sectors, tailoring portfolios to meet individual investor needs and preferences. This level of personalization ensures that portfolios are optimized for financial performance and reflect personal investment criteria and risk tolerances.
How We Use Direct Indexing to Support Our Investor Goals
Direct indexing allows us to take an existing highly concentrated stock position or outside portfolio and integrate it into our portfolios at Wealth Advisors of Tampa Bay in a tax-efficient manner over time.
As a result, our investor clients are able to benefit from having a personalized portfolio that accomplishes a few important goals:
It replicates an index.
It enables us to manage taxes efficiently (tax-loss harvesting, for example).
It helps the investor maintain the desired risk profile, based on their unique tolerance for risk.
Here’s a simple example of what direct indexing may look like for our clients:
Say an account or trust has low cost basis stocks, which means selling would result in high tax implications. To help mitigate the potential tax liability, we may determine the best course of action is to delay the sale of shares in a home improvement retailer to strategically purchase shares in a comparable company within the same sector.
Using Direct Indexing to Manage Concentration Risk and Mitigate Tax Liability
Typically, when a single stock makes up a significant percentage of your portfolio (say 10%), it can induce unwanted single security risk and sector exposure—meaning your portfolio is overconcentrated. While your portfolio likely didn’t start out this way, its make-up changes over time for a few common reasons. Maybe certain assets have performed exceptionally well, you received a large chunk of equity compensation from your employer, or you inherited stocks from a loved one.
No matter how your portfolio came to be overconcentrated, direct indexing is one strategy we can use to help manage the risks tied to significant single-stock exposure.
An Example of Strategic Reduction of Concentrated Stock Exposures
Consider a scenario where a bank stock, initially purchased at a cost basis of $75,000, has appreciated to $250,000—for a capital gain of $175,000. Now, the stock constitutes a significant portion (roughly 25%) of a $1 million dividend growth portfolio.
Selling this stock outright could generate substantial capital gains taxes. However, we cannot leave the portfolio overconcentrated in one stock. Not only does it skew the portfolio’s risk profile, but that capital could be used to pursue other investment opportunities for our client.
Our Solution
Here’s what we decide to do: We establish parameters like a capital gains budget or a targeted reduction timeline. Leveraging technology, we gradually realign the portfolio to reduce the stock's dominance, achieving tax efficiency with minimal impact on the portfolio’s overall risk profile.
Because this is a dividend growth portfolio, we decide to target an index like the S&P Dividend Aristocrat Index and set an annual capital gains budget (e.g. $40,000) to help manage the impact. Then, we determine a targeted allocation for the concentrated stock—aiming to reduce its portion from 25% to 7.5% over three years.
With these parameters (and others) in mind, we look for opportunities to implement a tax-loss harvesting strategy. As a reminder, this would enable us to offset potential gains from the concentrated stock with embedded losses in the portfolio. For example, we may sell a loss in a stock associated with a fast-food chain and buy a similar fast-food stock.
We also have the ability to sell an individual stock and replace it with an index—for example, we can sell a loss in a blue-chip energy company and buy an energy index fund. Using technology, we can identify short-term replacements within the same sector, thereby managing risk and reducing taxable gains.
Tailoring Inherited Portfolios with Direct Indexing
This same strategy can be used to transition an inherited portfolio or trust into a customized portfolio allocated toward your own goals and risk tolerance. We’ve found that this can typically take three to five years, depending on the parameters. Generally speaking, however, the broader the parameters and the capital gain recognition, the faster the portfolio can be migrated. Once the portfolio has been migrated, we can exit the direct indexing technology.
A Powerful Tool for Portfolio Optimization
For investors looking to achieve greater customization and tax efficiency in their portfolios, direct indexing may be an option worth considering. On your own, however, direct indexing can be a time-consuming and challenging process—just imagine researching specific indices, placing individual orders for hundreds of stocks, and continuously updating the account to parallel the index (which fluctuates regularly).
To help our investors access the benefits of direct indexing without the time-intensive commitment of building an index from scratch, we leverage a proprietary direct indexing tool that enables us to streamline the process.
Through direct indexing, we’ve been able to help our clients refine their investment strategies with highly personalized and tax-efficient approaches.
Ready to explore how direct indexing can benefit your financial portfolio? Contact Wealth Advisors of Tampa Bay today to schedule a personalized consultation and start optimizing your investment approach.
Sources:
1 https://www.nasdaq.com/articles/direct-indexing-growth-to-outpace-etfs-mutual-funds-smas
3 https://www.investopedia.com/articles/exchangetradedfunds/12/brief-history-exchange-traded-funds.asp
4 https://www.smartleaf.com/our-thinking/smartleaf-blog/direct-indexes-are-better-than-etfs
Robert "Fenn" Giles, Jr., MBA, CIMA® is the Founder of Wealth Advisors of Tampa Bay and acts as the firm's President and Chief Investment Officer. WATB is an independent Registered Investment Advisor (RIA) located in Tampa, Florida. Learn more about them at wealthadvtb.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All indices are unmanaged and may not be invested into directly.
All investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon.
