Direct and Custom Indexing: Finding the Right Strategy

Most investors are familiar with index investing. As I have mentioned above, the S&P 500 produces positive returns over 75% of the time, so a smart stock investing strategy is to buy a low-cost S&P 500 index and just let it grow for the long-term. However, if you are in a high tax bracket and/or have accumulated significant portfolio assets, there are several reasons why the old “buy an index fund” may not be the best advice.

One key reason is that taxes can significantly impact your returns!  If you accumulate significant money in an index fund over time, you will be faced with an uncomfortable decision at some point:  When to sell profits and pay taxes on your capital gains. Massive profits in a single fund will generate massive taxable gains.

Direct indexing provides a way to improve after-tax returns over time.  Direct indexing involves investing in a stock index by holding the actual underlying stocks rather than a fund.  Through an active indexing strategy, a portfolio manager can harvest losses during the year from underperforming positions and use those losses to offset current or future gains.

As you can see in the chart above, almost 75% of stocks in the S&P 500 experience a drawdown of 5% or more in any given year, despite the index producing positive returns.  Through direct indexing we can put those losses to work, but still take part in the overall positive performance of the index.

Custom-indexing is another benefit of direct indexing.  Depending on your appetite for risk, your political preference, your faith, or any other personal intentions that impact your preferences as an investor, you may want to customize your involvement in a business, sector or industry.  Through a custom index you can choose to remove exposure or to enhance exposure to certain stocks, industries or factors.

We recommend a minimum asset level of $250k in a taxable investment account to utilize this type of strategy.

We can help you determine the right strategy for you. As with every part of Centered Financial’s investment process, direct indexing is driven by the objectives in your financial plan.

Have investment questions? We're here to help. Schedule a call a complimentary Basics of Investing Zoom Session here. 

Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.