One of the major benefits of direct indexing is that tax losses can be harvested during up and down years. This option is not available to clients who are invested in indices. This is because clients will own the actual components of an index in their account rather than an ETF or a mutual fund. With regular scans, losing positions can be sold to harvest tax losses which can then be used to offset gains in the future or other parts of the portfolio.
This is because some components of the index will be in the red even in up years. These positions are sold and then other stocks with similar factor scores are added to ensure the benchmark continues to be tracked.
According to Vanguard, “Because investors directly own the individual securities in their direct indexing portfolios, you can harvest losses for them even in years when the index is up. You can use these losses to offset your clients’ capital gains, and help them keep more of what their portfolios earn.” Overall, it believes that the strategy can add between 1% and 2% in annual returns in after-tax alpha for clients with large capital gains in addition to helping optimize short and long-term holding periods to minimize capital gains taxes.
Finsum: Direct indexing has several benefits for investors such as tax-loss harvesting. While many are familiar with its application during down years, less are aware that it can be used to add alpha even in up years.