A wealth management consultant’s quick guide to direct indexing

Many of our high-net-worth clients need ways to reduce their tax burden, and as a wealth management consultant firm, we’re getting lots of questions about direct indexing. Here’s a quick guide to this investment strategy, the possible benefits and drawbacks of including it in your portfolio, and how to learn more.

What is direct indexing?

Index investing is a popular and proven way to invest in the stock market while managing risk, spreading that investment across many stocks. Mutual funds and exchange-traded funds are two types of index investing, but they don’t offer much investor input and they only offer trading of underlying securities.

Direct indexing, however, gives the investor more control over investments and ownership of the actual assets instead of buying into an index fund. Many investors want to put their money behind companies that align with their personal values, and direct indexing offers that option through greater investor input.

Setting up this type of investment strategy usually requires setting up a separately managed account (SMA). This type of investment accounts allows the investor to be selective about which stocks they purchase and when they trade the assets they own, which can afford high-net-worth investors some tax benefits.

Direct indexing benefits and cautions

The most attractive feature of direct indexing is the ability to customize investments based on personal values and tax liability.

Direct indexing investors can sell under-performing stocks for a loss. While that’s not typically an investment strategy that makes sense, for those with larger tax burdens, it can reduce the total amount owed through tax-loss harvesting. The benefit to the investor is a short-term reduction in taxes due, with the option to re-purchase the stock at a bargain price later if it’s projected to increase in value. Using that strategy, it’s possible to reduce tax liability and reach investment goals more quickly.

Any wealth management consultant will tell you that direct indexing should be approached methodically and with caution. Fees for this type of investing are typically higher than other index options, so it’s important to consider your personal financial goals and timeline before diving into the direct indexing chess game.

In addition to higher fees, direct indexing investment minimums are much higher than mutual fund or ETF minimums. Opening an SMA requires at least $100,000, which is why direct indexing is most appealing to high-net-worth investors. Another potential pitfall of direct indexing is tracking errors, which occur when stocks under-perform when compared to the index, resulting in lower returns.

Talk with a local wealth management consultant

At Good Life Asset Strategies, our investment and wealth management consultants are always ready to talk through the pros and cons of any investment strategy. Our clients are current and potential high-net-worth investors, so we understand the intricacies of balancing returns with tax burdens, personal financial goals, and individualized timelines. Contact us today to talk through direct indexing and see if it’s a good fit for you. Our job is to do what’s best for our clients, and you can trust our advisors to steer you in the right direction.