The Benefits of Direct Indexing for Transitioning Portfolios

Abstract

Direct indexing can provide substantial tax benefits over ETFs for a variety of common transitioning activities, such as repositioning and rebalancing. The authors show examples where common style or capitalization rotations can be performed at a fraction of the tax cost with direct indexing, using the concept of weighted name overlap to illustrate the weight of holdings that would not need to turn over and could thereby avoid incurring realized gains. The authors then introduce the concept of optimizing a transition from an appreciated direct index to another direct index by allowing tracking error to reduce turnover. To help advisors decide when to use direct indexing over straightforward index ETF vehicles, the authors describe key considerations, including client tax rate, holding period, name or factor overlap, index cross-sectional dispersion, and the frequency of active repositioning.