Direct Indexing: The Ultra Wealthy’s Secret Edge

Ever heard of Tax Alpha or Tax-Loss Harvesting?

If not, you may be leaving significant performance gains on the table. Let's dive into why.
If you're invested in an ETF, especially one tracking a major index like the S&P 500, you own every security that is part of the index.  You cannot sell loss positions to “harvest” or recognize losses and then use those losses to offset capital gains from other positions, including those from other asset classes.

You cannot tax-loss harvest an index-tracking fund because you own interests in the fund, instead of the individual securities.  But with Direct Indexing, you can.

Direct Indexing enables you to build a separately managed account that replicates a stock index, such as the S&P 500 or the Russell 3000, enabling you to directly own the individual stocks that make up the chosen index.
The Direct Indexing Advantage
Morgan Stanley's research reveals a compelling insight: from 1998 to 2021, Direct Indexing could have enhanced your annualized gains by about 2% (shown in the next section) compared to traditional ETFs. On a $1MM portfolio, this translates to a staggering additional $1.8 Million!With direct indexing, you're not just tracking an index like the S&P 500; you're owning every individual security within it. This ownership unlocks the potential of ‘tax loss harvesting’ across the entire index.
Aligning Your Investments with Your Goals and Values
Direct indexing offers another benefit that you cannot obtain with a typical index fund:  the ability to customize your portfolios’ holdings to align more closely with your financial goals or personal values.

For example, if you are environmentally conscious, direct indexing allows you to selectively avoid companies with high carbon emissions. Or perhaps you believe you are overexposed to a certain stock or sector that you view as risky; direct indexing can allow you to diversify around that position to help mitigate the risk.
Capitalizing on Market Dynamics
Even in a year when the index shines green, individual securities might be underperforming. In 2022, a staggering 91% of stocks in the S&P 500 offered a ‘tax loss harvesting’ opportunity. By selling these underperformers, you could realize tax losses, offsetting capital gains elsewhere.

After selling an underperforming stock, the proceeds can be strategically reinvested in a correlated stock, ensuring you remain exposed to the index's potential upside.
The Role of Technology
Direct Indexing software leverages algorithmic strategies to execute buy and sell orders, ensuring you benefit from tax losses while still tracking the index's trajectory. While this strategy previously was too expensive and only available to the ultra wealthy, technology breakthroughs, fractional ownership of shares, automation and near zero commissions on trades have made direct indexing accessible to a broader investor base, and for varied purposes beyond just tax-loss harvesting.

Traditional ETFs vs. Direct Indexing: Tax Alpha & Tax Loss Harvesting

Imagine the S&P500 dipping 10% mid-year but recovering to end 2% up. With the usual annual "tax loss harvesting," you'd find no losses to claim. But Direct Indexing offers a different narrative.
The Proof is in the Numbers
While ETFs come with their own fees, the real cost is the missed "tax alpha" – the potential gains from proactively managing your portfolio to offset realized tax losses. Direct Indexing isn't just about diversification; it's about optimizing returns.

Morgan Stanley's extensive backtest, spanning events like the DotCom crash, the 2008 crisis, and the 2010s, reveal a compelling narrative. Direct Indexing has the potential to outperform passive ETF investing by approximately 2%, especially in bear markets. The magic of compounding this 2% over time? Substantial.
Simplifying Tax Loss Harvesting (TLH) & Tax Alpha
TLH is a financial strategy employed by advisors to help mitigate tax liabilities from capital gains.

Under this: Advisors can sell underperforming stocks, realizing a tax loss. And to stay compliant of the "wash sale" rule, they may repurchase the same securities after a 30-day window.

Benefits: The realized losses can offset capital gains, reducing the current year's tax burden.This is especially useful for those with unexpected capital gains, like from a property sale. Unused losses can often be carried forward, offsetting future capital gains.

In essence, TLH is a proactive approach to manage potential tax bills, enabling investors to improve their overall returns.
Example 1

Investor facing substantial capital gains tax

The Situation: You've sold assets, realizing a capital gain of $300,000, and now face a capital gains tax. Simultaneously, your $200,000 investment in the S&P500, whether through ETFs or Direct Indexing, stands at $205,000; despite 450 out of 500 securities underperforming in the index.

Scenario A: The ETF Path

Investment Method: Holding an ETF mirroring the S&P500.

Tax Season Reality: No losses to harvest despite underperformers due to overall positive index performance.

Tax Implication: A 15% tax on the full $300,000 gain, equating to a $45,000 tax bill. No mitigation strategy in place.

Scenario B: The Direct Indexing Path

Investment Method: Utilizing Direct Indexing, holding a basket of individual securities mirroring the S&P500.

Advantage: The Direct Indexing software sells underperforming securities during the year, realizing losses of $60,000, and buys similar ones to maintain index tracking.

Tax Season Reality: The $60,000 loss is strategically offset against your $300,000 capital gains, reducing taxable income to $240,000.

Tax Implication: A 15% tax on the reduced $240,000 gain, lowers the tax bill to $36,000, saving you $9,000.

The "Tax Alpha" Advantage
The $9,000 saved isn’t just a tax shield, it's being reinvested, and compounded, potentially enhancing future gains.
Key Takeaway
Direct Indexing, through strategic Tax Loss Harvesting, not only navigates through tax liabilities but also reinvests, optimizing your financial trajectory amidst the market’s ups and downs. Your capital is always working for you and not the other way around.
Example 2

Navigating Concentrated Stock Holdings for Entrepreneurs and Early Employees

Startups going public often mean founders and early employees have most of their wealth in company stock. To diversify and avoid hefty capital gains taxes, with Direct Indexing, entrepreneurs can offset the gains against accumulated realized tax losses.

Even post-IPO, employees at tech giants like Facebook and Microsoft face the risk of overexposure to tech. With Direct Indexing, they can create a portfolio that reduces tech stock exposure, ensuring diversification and lower tech sector volatility while tracking the index.
So Why Choose Direct Indexing?

Tax Alpha

Harness immediate tax savings and enjoy the potential of long-term wealth creation.


Whether it's aligning values, sidestepping sector risks, or capitalizing on tax rate shifts, Direct Indexing adapts to your financial goals.

Your Next Step: In the current market environment of sudden rate hikes and volatility the opportunity is ripe to deploy Direct Indexing into your portfolio. We're eager to hear your thoughts and discuss how it can be tailored to your unique financial journey.Consider joining our waitlist, by pressing the button below,  if you are ready to explore this opportunity for your portfolio.

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Ram Ahluwalia Headshot
Ram Ahluwalia, CFA
CEO, Co-Founder Lumida Wealth

Ram, has 20+ years of experience in management and investments. He founded Cross River Crypto, was CEO of PeerIQ (acquired by Cross River Bank), and held executive roles at Bank of America and Merrill Lynch. Ram is a CFA Charterholder with a BA in Philosophy and Economics from Columbia College.

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Justin Guilder
COO, Co-Founder Lumida Wealth

Justin, has 18+ years of experience in corporate operations, finance, legal, compliance, and investments. He co-founded Reserve Trust, served as Managing Director at PennAve One, and practiced law at Dentons and Kilpatrick Townsend. Justin holds a JD from The George Washington University Law School and a BA in Business Administration from the University of Florida.