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Direct Indexing: A Tax-Efficient Alternative?

Picture the contents of a contemporary retirement portfolio. What do you find? You’ll likely encounter a mix of Mutual Funds, ETFs, and individual stocks and bonds. You might also spot some annuities, life insurance policies, and CDs or Money Markets for that all-important liquidity.
If that’s what your portfolio looks like, you’re off to an excellent start. You’ve achieved a diversified asset mix designed to weather various market conditions and life events while providing tax efficiency. However, good can always be better—especially when it comes to optimizing your tax situation. Enter Direct Indexing, a dynamic strategy that could revolutionize your approach to investing.

What is an Index?

To better understand Direct Indexing, it’s essential to grasp what an index is and what purpose it serves. An index serves as a barometer for the overall performance of a market or a specific sector within that market. It provides investors and financial professionals a useful benchmark for comparing individual asset or portfolio performance against the broader market.
A good example is the S&P 500, which represents 500 of the top companies in America, weighted in proportion to their market capitalization. Apple, Microsoft, Amazon, Nvidia, and Alphabet (Google’s parent corporation) currently top the list. The index continuously tracks market fluctuations and employs sophisticated software to automatically adjust weights as necessary.
This real-time snapshot of market performance helps investors make informed decisions about buying and selling assets, providing a reference point for evaluating the effectiveness of different investment strategies.

What is an Index Fund?

The S&P 500 doesn’t ‘own’ any of the stocks in the index – it merely tracks them. An index fund, on the other hand, does own the individual stocks of an index and attempts to mirror the index’s composition within the fund.
This means that in a Mutual Fund or ETF that tracks the S&P 500, Apple has a higher weight in that fund than, say, Alphabet. If Alphabet’s market cap goes over Apple’s, then the weights are adjusted by buying more Alphabet stock and selling Apple’s. This is a ‘passive management’ investment approach.
Some popular index funds include SPY, Fidelity’s ZERO Large Cap Index Fund, and Vanguard’s Growth ETF.
When you purchase an ETF or Mutual Fund, you do not own the individual stocks and bonds that comprise the fund – you’re instead a shareholder in a collective pool. The fund itself owns those stocks and bonds and divides the profits amongst those who purchased the index fund. The upside is that you have access to the earnings of all those companies without having to buy the actual stock, making them overall more accessible to your average investor. The downside is that you cannot customize the fund and have fewer tax-loss harvesting possibilities. Also, how these funds are managed can significantly influence your potential returns and the fees you’ll incur.

Passive Management

Fund managers who engage in passive management mirror an existing index like the S&P 500. They pay close attention to the composition of the index they’re tracking, buying and selling stocks to keep the fund’s portfolio aligned with the index. Because the strategy is to follow the market rather than beat it, passive management typically has lower fees than its active counterpart.

Active Management

On the flip side, active management involves a fund manager creating their own portfolio of stocks based on individual analyses and market projections in an attempt to achieve higher-than-average returns. This approach demands a lot more time, effort, and research, which explains why fees for active management are generally higher. As there is no attempt to mirror an index, actively managed ETFs or Mutual Funds are not index funds.

What is Direct Indexing?

Finally, to the good stuff! Now that we have a firm grasp of what an index and an index fund are, we can delve into direct indexing.
With Direct Indexing via a Separately Managed Account (SMA), you don’t just possess a ticket to the show – you’re the owner of the theater. Direct Indexing also tracks an index, but the difference is that you, the owner, physically own all the stocks and bonds associated with that index.
Direct Indexing straddles the line between passive and active investing. It allows investors to start with a baseline (the index) but then tweak it based on personal preferences, goals, or beliefs.
In this sense, Direct Indexing offers a sort of “customized passivity.” You’re not making day-to-day trading decisions based on market predictions, as you would in a fully active strategy. But you’re also not simply buying the market and forgetting it; you’re making strategic decisions that reflect your personal investment stance.
This, of course, opens up a world of opportunities for customization while still maintaining the principle of diversification – as long as you don’t overly customize it.
If you’ve never heard of Direct Indexing, it’s not a surprise. Although it’s been around for years, it was until somewhat recently primarily used only by Ultra-High-Net-Worth Individuals, as purchasing and managing all of the assets in a fund can quickly become an expensive ordeal.
Recent advancements have lowered the overall costs and significantly lowered the barrier to entry for the everyday investor. These advancements include the availability of fractional stock purchases and cutting-edge software that automatically adjusts your personal index and seeks out tax-saving opportunities.

In Conclusion

From offering greater customization to expanding tax-saving opportunities, Direct Indexing isn’t just for the ultra-wealthy anymore. It combines elements of passive and active management, giving you the control to tailor your investments according to your personal needs and beliefs.
At Walters Strategic Advisors, we’re excited to offer Direct Indexing via Separately Managed Accounts (SMAs). As dual-focused tax advisors and fiduciary financial advisors, we’re ideally positioned to take full advantage of Direct Indexing, aligning this innovative investment strategy with your comprehensive financial plan for optimal tax efficiency.
In our next article, we’ll dive into the specific benefits of Direct Indexing via an SMA. You’ll learn how this option could not only optimize your returns but also fit perfectly within a diversified investment strategy.
If you’d like to discover if Direct Investing aligns with your financial goals, click the button below!

About the Authors

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.

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  • Jose Joia

    Jose M. Joia is a Wealth Advisor at Walters Strategic Advisors, LLC. As a member of the team, Jose’s responsibilities involve comprehensive wealth management, planning and customer service. He has over 6 years of industry experience specializing in planning and solving unique issues his clients encounter. Jose has experience serving individual clients, business owners and non-profit organizations.

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