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An Introduction to Direct Indexing

<p>An Introduction to Direct Indexing</p>

Investors today seek more than just market-average returns. They’re looking for strategies that deliver after-tax outperformance, align with their financial goals, improve tax efficiency, and reflect their personal values. Direct indexing seeks to meet these needs by offering index-like exposure through custom equity portfolios, enhancing after-tax outcomes and allowing for greater personalization. In other words, direct indexing can deliver on investors’ search for more and better. 

This paper introduces direct indexing by revisiting its foundational principles of index investing and tax-loss harvesting — two key components of a tax-efficient portfolio. We then present the case that by combining index investing and tax loss harvesting, direct indexing offers the potential for outperformance through “tax alpha,” which is the additional return from tax benefits unavailable with traditional index funds or exchange-traded funds (ETFs).

Next, we examine the technological and structural developments that made direct indexing feasible, and assess the size and consistency of tax alpha over time. 

Finally, we explore the customization potential of direct indexing, identify the types of investors who might stand to benefit most, and outline the key risks they should consider.

Key Takeaways

  • Direct indexing offers a modern solution for investors seeking higher after-tax returns, personalization, and control. By enabling direct ownership of individual stocks, direct indexing unlocks tax-loss harvesting opportunities that traditional index funds cannot provide — potentially adding 1%–2%1 in annual tax alpha.
  • Direct indexing’s value extends beyond tax benefits. It allows investors to tailor portfolios around concentrated positions, personal values, or estate-planning goals. It’s a strategy that might be suitable for high-income investors, business owners, and those with capital gains arising elsewhere in their portfolios.
  • Direct indexing portfolios are not without risk. Investors should weigh the likelihood of tracking error, the need for offsetting gains, and potential tax law changes before proceeding. Additionally, Direct Indexing may involve higher management fees than traditional index funds due to its personalized nature and tax optimization features.
  • As technology advances and investor needs evolve, direct indexing stands out as a cutting-edge approach that delivers more — and better — outcomes for today’s tax-aware investor.
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Neuberger Berman; Shomesh E. Chaudhuri, Terence C. Burnham and Andrew W. Lo., 2020, “An Empirical Evaluation of Tax-Loss-Harvesting Alpha.

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