Direct Indexing=Alpha

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Happy Sunday,

You might be hearing more about “direct indexing” soon, especially with all these fin-tech companies popping up. I figured I’d come in and make some comments about it, shed a little light on the topic for you.

So, what is it? Direct indexing means you’re purchasing the individual stocks that make up an index (like the S&P 500) rather than just buying an index fund ETF.

The principle behind it is pretty simple.

You still aim to match the overall index's performance. But here's the twist: you can often create a useful tax loss. Sometimes, this loss can reach 30-40% of your investment in a year. When your portfolio is re-balanced, you sell stocks that have lost value. This can also happen when the managing service does it. These are the "losers" from the year. This is what creates the valuable tax write-offs. You can do this without sacrificing that traditional “Index fund” style market exposure you’re used to.

I can guess what you’re thinking.

“There’s no way I’m buying all 500 S&P companies and moving them daily for a year." And you’re right, that would be insane. Thank goodness for technology. Many large companies and new fin-techs offer automated tax-loss harvesting tools. They can set this up for pretty much any index you want to try it out on. It’s a set it and forget it loophole for now.

Let Me Give You a Real-Life Example

Imagine I buy a $1M house to raise my kids in. Fast forward 20 years, I’m an empty nester, and the house could be worth $2-3M (which, let’s be honest, is a conservative estimate for real estate growth in many places). I plan to retire around the same time, sell the house, and relocate somewhere more chill.

So, let’s say I make a $2M profit on that home sale. After the $500,000 homeowners’ exclusion (if it’s my primary residence), I’m still looking at $1.5M in capital gains that could be taxed at close to 40%! That’s a huge chunk of change going to Uncle Sam.

But hey, look over here! If I’ve also had a Direct Indexing account, it’s likely been throwing off losses from individual stocks every single year, even in years when the overall market was up. I can then use those accumulated losses to offset a good chunk of my house sale gains, lowering that hefty tax bill significantly. See how that works?

There’s “Alpha” in Smart Tax Strategy

Most people should not be trying to find alpha – trying to beat the market – on the investment side by trying to pick winning stocks. We all know trading is hard, and in my opinion, it’s essentially a full-time job. That’s why straightforward investing and ETFs are so robust and common.

If you can be smart about saving money on taxes, that is where your market alpha can come from as an investor. This approach is not about outsmarting the market, but about being efficient with what the tax code allows.

What About the Cost?

Traditional index ETFs are cheap, usually charging fees around 0.03%. Direct indexing costs more. This is because it requires active management of individual stocks and tax-loss harvesting. You’ll find direct indexing services charging from 0.09% to 0.70%, and sometimes even more.

This may seem like a big jump. Many people find the extra cost worthwhile, especially for those who can gain from tax losses. The tax advantages can often outweigh the higher fees and usually do.

Is It For You?

It tends to make the most sense if you’re in a higher tax bracket, have a good chunk of money in a regular (taxable) brokerage account, or expect some big capital gains down the line (like selling a business or property).

It’s another tool in the toolbox. And like any tool, it’s good to understand how it works and if it fits your situation before you start using it. Might be worth looking into if any of this sounds like it could help you out. As always, chat with a financial advisor and see if its a good fit.

- John

This analysis reflects Pivot and Flow’s views and isn’t personalized advice. All investments carry risk, including complete loss of principal.

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