What is direct indexing?
Simply, instead of buying a specific index fund (like the S&P 500, Total U.S. market, etc), you buy individual stocks instead that comprise that particular index. In return, you can tax-loss harvest more:
How direct indexing actually works:
- The platform will buy individual stocks that track an index
- Allows tax-loss harvesting (this is the main value proposition)
- You don’t have to do any of the work yourself. Use different platforms (more on this in a bit), but comes with a cost
Is tax-harvesting even worth it?
In the research paper “An Empirical Evaluation of Tax-Loss-Harvesting Alpha” the researchers studied a scenario where:
- You deposit 1% of the gross portfolio value per month into 500 stocks
- Tax credit is treated as a cash flow (i.e. tax savings generated via tax-loss harvesting are reinvested into the portfolio)
- A marginal tax rate of 35% and a 15% long-term capital gains tax are applied
- The investor has capital gains that the losses can be applied to
They found that the “tax alpha” (or in simple terms, the additional value achieved by managing taxes efficiently through investment strategy) ranges from 0.58% to 2.29% annually, with an average of around 0.85%.
So, there is a significant benefit to tax-loss harvesting under the right circumstances.
Research also shows that the maximum net capital loss harvested is around 30% over a 10-year initial investment period (Israelov and Lu, 2022; Liberman et al., 2023). This means that if you invest $100,000, roughly $30,000 could be harvested as losses over 10 years via direct indexing.
Cost
If you’ve been reading this newsletter for a while, you know that I’m a big proponent of minimizing fees.
I don’t buy any ETFs with an expense ratio higher than 0.1%. This is because fees compound over time.
So, how would direct indexing compare to something like VTI?
Now, there are a lot of companies that offer direct indexing and tax-loss harvesting done for you. One of the lowest I could find is Wealthfront, with a 0.09% expense ratio tracking the S&P 500 ($20,000 minimum). BUT I would be cautious using that (more on this in a bit).
Fidelity charges 0.4% with a $5,000 minimum.
Schwab charges 0.4% with a $100,000 minimum.
Vanguard charges 0.2% with a $250,000 minimum (but it looks like a relatively new offering tailored toward advisors).
What is the usefulness of direct indexing and tax loss harvesting?
1. Generate large losses
Research has shown that by using direct indexing, you will be able to generate about 2x more losses than doing it manually (i.e. between VTI/VOO).
This is because the S&P 500 is down 3.56% YTD, but ~59 stocks are down 20% or more, which you would be able to harvest with direct indexing:
However, you have to continuously keep contributing to the account. This is because the market goes up over time, and you wouldn’t be able to find opportunities to harvest.
So, if you are a few years away from retirement, it might not make much sense to overpay the fees.
2. Tax benefits
First, you can deduct $3,000 of losses against your ordinary income (i.e. W-2 wages). The rest is carried forward indefinitely (but applied to other gains first).
Also, if you are in a high tax bracket, you might pay 23.8% on capital gains (20% LTCG + 3.8% NIIT).
In addition, states like California treat all capital gains as ordinary income, potentially having a 30%+ tax on capital gains.
So, you will generate a lot of losses from direct indexing, apply them against gains, and minimize your taxes.
Then, during retirement, you will be in a lower tax bracket (even 0% if you stay below the income limits) to realize the gains from harvesting.
3. Have other capital gains
If you anticipate other capital gains that you would eventually like to cancel out, tax-loss harvesting makes sense.
For example, if you have RSUs that are held to LTCG.
Or say you own a home in an HCOL area that could appreciate $1M in the next 20 years when you retire.
Currently, you have an exemption of $500K (if married), but then you might be stuck with $500K of capital gains.
That could mean ~$150,000 in taxes. But imagine you already have $500K of losses generated via direct indexing and harvesting.
Now, drawbacks:
1. Unwinding
When you want to withdraw from direct indexing, the platforms will usually sell in a way that minimizes capital gains.
However, you don’t typically have to sell.
You could just transfer the entire mix of 500+ stocks into a regular brokerage account and sit on it with ACATS.
But that still means you have 500+ stocks to manage. You will have to figure out how to eventually sell them in an efficient way (which could be during retirement, as you might be in a lower tax bracket).
In addition, here are 3 additional strategies to manage unwinding:
- Donating appreciated shares
- Step-up in cost basis at death. If you pass all 500 stocks down to others, they can just sell them without incurring capital gains.
- Sell the 400 lowest-performing stocks (which might not have too many gains). You will be left with ~top 100, and can buy the S&P 400 for the mid-cap companies, while keeping the 100.
2. Startups fail or get acquired
Remember that I mentioned the 0.09% expense ratio with Wealthfront?
There could be a possibility that they might get acquired or their fees might get raised to sustain the business.
In which case, you might not have many options. It’s worth looking at whether other providers of Direct Indexing would accept 500+ stocks from another provider via ACATS.
Or, If you want to do direct indexing, I would want to do it at a big, well-established firm with a good track record of staying committed to the products they’ve launched.
3. Tax complications
Since the index is constantly selling and buying, you will have hundreds of trades. Your 1099 will be hundreds of pages.
However, this shouldn’t really be a problem, as you can enter a summary of your transactions. But it’s just something to keep in mind in case your CPA charges extra.
4. Tracking error
There is a risk that the direct index will sell a position, buy back a similar stock, and miss out on a big rally of the initial one within the 30-day period.
Think selling Nvidia, buying AMD, and Nvidia rallies within 30 days.
In addition, over the long term, your individual stocks tracking an index will eventually deviate slightly from the index.
So, what are some scenarios to consider getting into direct indexing?
- You are in the top tax brackets (Federal + State)
- You have substantial ongoing capital gains or will realize substantial gains soon
- You are at least 10-15 years away from retirement or are contributing significant amounts
- You plan to leave assets to heirs or are charitably inclined
Alternatively, you could DIY between ETFs but will realize fewer losses.
Summary
Direct indexing can be powerful, but it’s really only worth it in specific situations.
For many investors. especially those close to retirement, who value simplicity, the eventual unwinding headaches may outweigh the upfront tax savings. Think long-term before committing.