Direct indexing combines the best elements of running a traditional portfolio with passively investing in indexes. This means that investors can reap the benefits of passive investing such as low costs, diversification, and proven long-term outperformance. Yet, they can still take advantage of tax loss harvesting which isn’t possible through investing in ETFs or mutual funds. 

This is because direct indexing leverages technology to recreate an index within an individual account. This technology will also regularly scan the portfolio for tax loss harvesting opportunities. Losing positions are sold and then replaced with positions that have similar factor scores to ensure that the index continues to be tracked. Over a whole year, this will lower an investors’ tax liability.

According to research, direct indexing will lead to an additional average annual return of 1.1%. Further, various direct indexing providers can optimize a portfolio according to an investors’ specific tax situation by offering various scenarios and the subsequent impact on capital gains. From an advisors’ perspective, many clients are interested in reducing taxes and aligning their investments with personal values. Direct indexing can help with both goals which means it can be quite potent in terms of recruiting and retaining clients. 

Finsum: Direct indexing can increase an investors’ average annual return by reducing tax liabilities. This is in addition to the typical benefits of passive investing such as diversification and low costs.