Morgan Stanley
  • Wealth Management
  • Oct 3, 2023

How Direct Indexing Can Offer Investors Potential Tax Savings and Flexibility

Learn more about the potential advantages of a direct indexing strategy and how it can help you meet your financial goals.

Steve Edwards Investment Strategist, Wealth Management

Many investors are familiar with mutual funds and exchange-traded funds (ETFs), which allow them to invest in a pre-selected “basket” of stocks, often to follow an existing market index. But fewer are aware of an approach called direct indexing, which also seeks to replicate an index’s performance but could also allow for greater tax efficiency and opportunities for individual customization. 

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Whether you are building a new portfolio or making changes to your current investments, direct indexing may be worth considering. Let’s take a closer look at how it works, as well as the potential benefits and drawbacks. 

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What Is Direct Indexing?

In a nutshell, direct indexing seeks to replicate an existing stock index, such as the S&P 500 or the Russell 3000, in a taxable account. Through a separately managed account, an investment manager establishes direct ownership of individual stocks that make up the chosen index. Using optimization software, the manager typically includes a sample of the index constituents, which allows for close mirroring of the index’s performance.

So, why not simply invest in a mutual fund or ETF that passively tracks your index of choice? With direct indexing, you have access to potential tax savings not typically possible when you own an index-tracking fund. You also tend to have more flexibility when it comes to the individual stocks you choose to own.

With direct indexing, you can tailor your portfolio to your values and goals.

Helping Reduce the Impact of Taxes

Perhaps the biggest potential benefit of direct indexing comes from the ability to use a strategy called tax-loss harvesting. This involves selling positions that are down—“harvesting” or recognizing the losses—and using those losses to offset capital gains from other positions, including those from other asset classes or managers. This strategy may help lower your tax bill.  Some direct indexing strategies or platforms may offer systemic solutions to automatically and opportunistically harvest tax losses year round.

Tax-loss harvesting typically isn’t an option with an index-tracking fund because you own interests in the fund, instead of the individual securities.

Even if you haven’t realized capital gains in a given year, you may still use up to $3,000 in realized losses to offset your ordinary income. Additionally, any leftover capital losses can be carried forward to future years. As your investments potentially grow over time, these incremental tax savings can add up in a big way.

To test the potential tax benefits an investor could gain with direct indexing with systematic, year-round tax-loss harvesting, we conducted a series of simulations that compared the strategy1 with passive ETFs and active investment strategies. Our research found:

  • Compared to index-tracking ETFs, in both historical and forward-looking testing, the direct indexing strategies with systematic, year-round tax-loss harvesting were more likely to deliver greater after-tax returns.
  • Direct indexing also tended to perform better than active strategies in certain asset classes, such as U.S. large-cap core equities, over shorter time horizons and with higher-income investors.

Investing for Your Goals and Values

Another potential benefit of direct indexing that you won’t find with a typical index fund is the ability to customize your portfolio’s holdings. Index ETFs are essentially a package deal—you get every stock that’s part of the index. But with direct indexing, you can tailor your holdings to align more closely with your financial goals or personal values.

For example, if you’re an environmentally conscious investor, direct indexing may allow you to avoid certain companies with high carbon emissions. Or perhaps you feel you have too much exposure to a certain stock or sector that you view as risky; direct indexing can help you diversify around that position to help mitigate the risk.

You can make adjustments as you see fit with help from a Financial Advisor who will monitor, periodically update and rebalance your investments so they don’t stray far from performance targets.

Is Direct Investing Right for You?

As with most investment strategies, there are limitations to consider before you dive into direct indexing. For example, the strategy may lead to higher management fees than investing in similar ETF strategies, because the level of customization may involve buying and selling securities that can lead to higher transaction costs. However, depending on your individual portfolio, the potential tax savings from harvesting losses may help to offset those costs.

In addition, when owning individual securities, direct indexing typically requires a relatively high minimum investment of $250,000. As such, if you’re interested in direct indexing but have assets held across multiple accounts at different institutions, you may need to consolidate your investments with a single Financial Advisor to realize the full potential of this strategy.

Direct indexing can be beneficial, but it typically requires a disciplined approach. Ask your Morgan Stanley Financial Advisor if the strategy may be right for you. Your Financial Advisor or Private Wealth Advisor has access to Morgan Stanley’s Total Tax 365 solutions that may help you implement a direct indexing strategy that’s tailored to your unique goals and needs.

You can learn more by listening to my brief audiocast or by requesting a  copy of Direct Indexing: Opportunities for Customization and Potential Tax Alpha.

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Our simulations assumed that the investment manager was implementing direct-indexing strategies that involved systematic, year-round tax-loss harvesting and was responsible for determining whether to recognize losses

Disclosures

Index Definitions:

Russell 3000 Index: Russell 3000 Index measures the performance of the 3,000 largest US companies based on total market capitalization.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Morgan Stanley Smith Barney LLC, its affiliates, Financial Advisors and Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.

Direct Indexing may adversely impact account performance. There is no guarantee that Direct indexing will produce the desired tax results. Morgan Stanley offers investment program services through a variety of investment programs, which are opened pursuant to written client agreements. Each program offers investment managers, funds and features that are not available in other programs; conversely, some investment managers, funds or investment strategies may be available in more than one program. Morgan Stanley’s investment advisory programs may require a minimum asset level and, depending on a client’s specific investment objectives and financial position, may not be appropriate for the client. Please see the applicable program disclosure document for more information, available at www.morganstanley.com/ADV or from your Financial Advisor. 

Tax-loss harvesting. IRS rules stipulate that if a security is sold by an investor at a tax loss, the tax loss will not be currently usable if the investor has acquired (or has entered into a contract or option on) the same or substantially identical securities 30 days before or after the sale that generated the loss.  This so-called “wash sale” rule is applied with respect to all of the investor’s transactions across all accounts.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on an exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock and bond prices. Investing in an international ETF also involves certain risks and considerations not typically associated with investing in an ETF that invests in the securities of U.S. issues, such as political, currency, economic and market risks. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. ETFs investing in physical commodities and commodity or currency futures have special tax considerations. Physical commodities may be treated as collectibles subject to a maximum 28% long-term capital gains rates, while futures are marked-to-market and may be subject to a blended 60% long- and 40% short-term capital gains tax rate. Rolling futures positions may create taxable events. For specifics and a greater explanation of possible risks with ETFs¸ along with the ETF’s investment objectives, charges and expenses, please consult a copy of the ETF’s prospectus.  Investing in sectors may be more volatile than diversifying across many industries. The investment return and principal value of ETF investments will fluctuate, so an investor’s ETF shares (Creation Units), if or when sold, may be worth more or less than the original cost.  ETFs are redeemable only in Creation Unit size through an Authorized Participant and are not individually redeemable from an ETF.

Investors should carefully consider the investment objectives and risks as well as charges and expenses of an exchange-traded fund or mutual fund before investing. The prospectus contains this and other important information about the mutual fund. To obtain a prospectus, contact your Financial Advisor or visit the mutual fund company’s website. Please read the prospectus carefully before investing.

The returns on a portfolio consisting primarily of environmental, social, and governance-aware investments (ESG) may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. The companies identified and investment examples are for illustrative purposes only and should not be deemed a recommendation to purchase, hold or sell any securities or investment products. They are intended to demonstrate the approaches taken by managers who focus on ESG criteria in their investment strategy. There can be no guarantee that a client's account will be managed as described herein.Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns include the reinvestment of all dividends, but do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment. Performance of indices may be more or less volatile than any investment product. The risk of loss in value of a specific investment is not the same as the risk of loss in a broad market index.

Strategy May Be Available as a Separately Managed Account or Mutual Fund

Strategies are sometimes available in Morgan Stanley Wealth Management investment advisory programs both in the form of a separately managed account (“SMA”) and a mutual fund. These may have different expenses and investment minimums. Your Financial Advisor or Private Wealth Advisor can provide more information on whether any particular strategy is available in more than one form in a particular investment advisory program.

Overlay Managers or Executing Sub-Managers (“managers”) in some of Morgan Stanley’s Separately Managed Account (“SMA”) programs may affect transactions through broker-dealers other than Morgan Stanley or our affiliates.  If your manager trades with another firm, you may be assessed costs by the other firm in addition to Morgan Stanley’s fees. Those costs will be included in the net price of the security, not separately reported on trade confirmations or account statements.  Certain managers have historically directed most, if not all, of their trades to outside firms.  Information provided by managers concerning trade execution away from Morgan Stanley is summarized at: www.morganstanley.com/wealth/investmentsolutions/pdfs/adv/sotresponse.pdf.  For more information on trading and costs, please refer to the ADV Brochure for your program(s), available at www.morganstanley.com/ADV, or contact your Financial Advisor/Private Wealth Advisor.

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