Direct Indexing: An Efficient Way to Turn Tax Losses Into Tax Assets

You’ve probably heard the phrase every cloud has a silver lining. It’s generally used when something bad happens that has a positive side effect. For example, let’s say your reservation at a restaurant was overlooked and you had to go somewhere else for dinner. And at the new restaurant, you ran into a friend you hadn’t seen in years.

Let’s consider the current volatility in financial markets as the cloud looming over the return potential of your clients’ portfolios this year. With the U.S. Federal Reserve rapidly hiking rates to rein in raging inflation, the ongoing war in the Ukraine and supply chain issues cutting into corporate profits, the outlook appears grim. But it does have a silver lining: the market’s ups and downs provide an ideal opportunity to tax-loss harvest. And an ideal opportunity to showcase how direct indexing is—by far—the most efficient way to reap the benefits of tax-loss harvesting.

The central goal of direct indexing is to build a portfolio that imitates an index mutual fund or exchange-traded fund (ETF) while maintaining all the flexibility of holding each security separately. The advantage that direct indexing holds in volatile markets is that since the investor owns the individual securities instead of a commingled fund, the losses that are taken on declining stocks belong to them. The investor can use those losses later to offset gains. That can be extremely helpful in reducing the investor’s tax bill.

Tax losses are tax benefits

As we’ve discussed previously, tax-loss harvesting by another name is tax-asset creation. While this may sound like Orwellian doublespeak, strategically selling some securities at a loss can be quite useful.

The thing is: capital gains are inevitable. No matter what the broader market does, there will always be some stocks that go up and some that go down.