What You Need to Know
- Morningstar's Ben Johnson discusses the drawbacks and the benefits of the overall strategy.
- It makes sense for only taxable accounts and usually requires high minimums.
- Ultimately there will be no more assets to sell to realize losses, and costs exceed owning a portfolio of diversified ETFs.
Like most investment strategies, direct indexing has drawbacks as well as benefits, but the benefits get the most attention.
The strategy involves individual securities owned in aggregate to resemble an index, but unlike an index ETF or mutual fund it allows for tax loss harvesting on a security-by-security basis, which can lead to greater savings. It also provides for greater customization of asset holdings, letting investors exclude, underweight or overweight individual assets to better reflect their preferences, including those related to combating climate change or stressing factors like value or momentum.
Direct indexing “is a capability; it’s a way of building a portfolio that meets very specific needs of individual investors that more often than not starts with an index,” explained Ben Johnson, director of global exchange-traded fund research at Morningstar in a recent Q&A on Morningstar.com.
But direct indexing also has drawbacks and limitations. For starters, it makes sense only for taxable accounts, since tax-loss harvesting is one of its key benefits, and is often available to those accounts held by high-net-worth or ultra-high net worth clients. Most strategies have a $250,000 or $500,000 minimum, as do most separately managed accounts (SMAs).
In addition, at some point the portfolio has no more assets to sell to realize losses to offset capital gains for tax purposes. It becomes “locked up,” and no longer generates the “tax alpha” it was designed for, according to Johnson.