By Tyler C. Gilley, CFP®, AIF®, Associate Wealth Advisor at Halbert Hargrove.
Understanding the Role of Enhanced Direct Indexing
In the ever-evolving landscape of investment strategies, enhanced direct indexing has emerged as a powerful tool for investors offering the potential to help manage tax liabilities and create opportunities for enhanced returns through sophisticated techniques. This blog analyzes the potential benefits of enhanced direct indexing, its core principles, and how it may be a useful tool in your investment approach.
The Usefulness of Enhanced Direct Indexing
Enhanced direct indexing may be particularly beneficial for investors who have accumulated significant unrealized capital gains. These gains, while generally indicative of successful investments, can pose a challenge when it comes to rebalancing portfolios or realizing profits due to the potential tax implications.
One of the primary advantages of this strategy is its ability to harvest tax losses. By strategically selling securities that have declined in value, investors may be able to offset gains from other investments, such as the sale of a highly appreciated home or other stocks in their portfolio, which can help reduce their overall tax liability. This process, known as Tax Loss Harvesting, can be particularly effective in volatile markets where price fluctuations create opportunities to realize losses without significantly altering the portfolio’s risk profile.
Moreover, enhanced direct indexing offers the potential for investors to diversify out of concentrated stock positions in a tax efficient way. Consider an investor with a brokerage account consisting of a small number of stocks that are worth considerably more today than when they were first purchased. The investor might desire to decrease the volatility of the stock portfolio, but the sale of those stocks would incur a very high tax liability which might dissuade the investor from making an otherwise prudent financial decision. An enhanced direct indexing strategy offers the potential to create tax losses that can help offset the tax impact from diversifying a portfolio into other asset classes, which can help reduce risk.
What is Direct Indexing?
To gain a better understanding of enhanced direct indexing, first, we must look at a similar strategy – direct indexing. At its core, this involves reconstructing a stock index using individual securities rather than investing in a traditional index fund. This approach allows investors to directly own underlying stocks of an index, providing the potential benefit of greater tax efficiency.
By owning individual securities, investors have the potential to engage in tax-loss harvesting more effectively by selling those securities that performed poorly, even when the overall index has a positive return during the same time period.
Consider the Russell 3000 Index, which serves as a benchmark for the entire US stock market. As of November 26, 2024, the index showed strong year-to-date returns, yet over 890 of its constituent stocks had negative returns (Source: YCharts). So even during periods of positive performance, direct indexing offers the potential to create opportunities to harvest tax losses at a more granular level.
Enhanced Direct Indexing: Leveraging Long and Short Positions
Enhanced direct indexing takes the principles of direct indexing a step further by using leverage to incorporate both long and short positions above and beyond the stocks already held in the portfolio. This strategy offers the potential to create additional opportunities for tax-loss harvesting, which may help enhance returns.
- Long Positions: In a long position, an investor buys a security with the expectation that its price will rise. This approach forms the basis of most investment portfolios.
- Short Positions: Short selling involves selling a security that the investor does not own, with the intention of buying it back at a lower price. This strategy seeks to profit from declining prices.
By combining long and short positions, enhanced direct indexing offers the potential for investors to take advantage of price movements in both directions in an effort to generate losses during rising and declining market environments. Furthermore, a manager can be strategic by applying a factor-weighted approach to incorporate long positions that demonstrate certain market factors (such as quality and momentum) and short positions that do not demonstrate those same factors. This dual approach may create more opportunities to harvest losses without sacrificing the total return of the investment portfolio.
Join Our Webinar to Learn More About Enhanced Direct Indexing
Given the sophistication of enhanced direct indexing, the strategy carries a minimum account size of typically $1 million, as well as specific funding criteria which must be met to allow the strategy to function as intended. Therefore, as with any investment strategy, it is important to work with your advisor to determine whether it might be appropriate for you and your financial goals.
If you would like to learn more, please consider joining our webinar on February 6th at 11:30 a.m. PST, with our Co-CIO, Brian Spinelli, and the team at AQR Capital Management. In this webinar, we will cover how direct indexing works, review use cases, and how to enhance direct indexing through a separately managed account. To register for the webinar, please click here, or contact us directly at HHTeam@hhga.com with any questions.
Disclosure:
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you conduct your own analysis and consult with professional advisors prior to making any investment decisions.
The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. The investment strategy discussed herein involves the use of margin. The use of margin poses additional risks beyond those associated with traditional long-only investment strategies. The use of margin may be unsuitable for some investors depending on their specific investment objectives and financial situation. You should carefully review any margin agreement to understand the risks and liabilities associated with utilizing margin.
There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially and should not be relied upon as such. This blog should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. This material should not be relied upon by you in evaluating the merits of investing in any securities, products, or strategies mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.
Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. There is no guarantee any forward-looking statement will come to pass. All opinions or views reflect the judgment of the author as of the publication date and are subject to change without notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index.
HH is not affiliated with AQR Capital Management.
