By Eric Rife, CFP®, CPWA® and Thomas Pudner, CPA, CFA, CFP®, MST Co-Chief Investment Officer and Co-Director of Research, Mason Investment Advisory Services
If you’re holding anywhere from one to hundreds of appreciated stocks and don’t want to trigger a large tax bill by selling outright, direct indexing is worth understanding. Unlike a Section 351 exchange, which calls for a diversified basket of securities to start, direct indexing can work even with just one or two concentrated holdings, provided you’re able to contribute some cash alongside them.
Direct indexing is an investment strategy where an account purchases the individual stocks within an index directly, rather than holding a fund that tracks it. This structure lets investors incorporate existing appreciated stock into the account while pursuing ongoing tax loss harvesting.
How Direct Indexing Works
Direct indexing is typically built through a separately managed account, commonly run on platforms like Aperio, BlackRock’s tax-managed equity SMA platform. Rather than buying a mutual fund or ETF that tracks an index, the account purchases the individual stocks in order to target an index or series of indices. Your existing appreciated shares are incorporated into the account alongside newly purchased positions, with the goal of constructing a portfolio that closely resembles a target diversified portfolio.
The more cash you contribute relative to your concentrated stock, the more closely the account can track the benchmark from the outset. The strategy looks for opportunities to harvest losses, selling positions that have declined in value and replacing them with similar, but not identical, holdings to avoid running afoul of the IRS wash sale rule. Those harvested losses can then be used to offset gains elsewhere in your portfolio, including gains generated as you gradually sell down your original concentrated position.
Who Direct Indexing Is a Good Fit For
Direct indexing tends to make the most sense for investors who:
- Hold one or several appreciated stocks they’d like to diversify
- Have the ability to contribute cash alongside their stock to help reduce tracking error against the benchmark
- Want ongoing tax loss harvesting built into their portfolio, not just a one-time tax-free conversion
It’s worth noting that direct indexing and a Section 351 exchange aren’t mutually exclusive over an investor’s lifetime. Some investors may use direct indexing first to begin managing concentration risk, then later consolidate into a Section 351 exchange ETF as their holdings diversify further.
What to Expect: Minimums, Costs, and Tradeoffs
Direct indexing platforms typically have account minimums in the low hundreds of thousands of dollars, making the strategy accessible to a broader range of investors than a Section 351 exchange, which may require several million in assets. Direct indexing is fee-based, charged as a percentage of assets in the account rather than a flat cost.
There are tradeoffs worth understanding before moving forward. Direct indexed accounts typically use ADRs rather than stocks listed directly on overseas exchanges, which narrows the international stock universe somewhat and tends to exclude small cap international names. The accounts also generally don’t include actively managed strategies. Additionally, the value of tax loss harvesting tends to be highest in the early years of an account and may diminish over time, absent a market correction or new cash contributions.
Direct Indexing vs. a Section 351 Exchange
If you’ve already read our piece on Section 351 exchanges, you may be wondering how the two strategies compare.
| Section 351 Exchange | Direct Indexing | |
| Starting positions required | Diversified basket (5+ stocks/ETFs typically) | Works with as few as one stock or as many as hundreds of stocks |
| Minimum assets | Several million, varies | Lower, typically low hundreds of thousands |
| Tax treatment | Tax-free conversion into new ETF | Loss harvesting offsets gains. Portfolio customized to incorporate stocks which best complement highly appreciated stocks |
| Cash required | Not necessarily | Helpful to reduce tracking error |
| Ongoing management | Less active once converted | Active, ongoing tax loss harvesting and management towards target allocation |
| Exit considerations | Often optimal to hold onto ETF until step-up or charitable gift if goal is to avoid taxable gain | More flexible, highly appreciated positions can be used to fund gifts to charity or friends and family while other positions can be harvested for tax losses or liquidated to fund spending |
A Section 351 exchange diversifies the underlying stock itself in a single tax-deferred event, but requires a more diversified starting basket and a higher minimum. Direct indexing has a lower entry point and incorporates oversight to manage tracking error, harvest losses, rather than an immediate diversification event.
How to Get Started
The right starting point depends on how many positions you’re holding, how much cash you’re able to contribute, and how quickly you’d like to reduce concentration risk. A conversation with your advisor can help map out which strategy, or combination of strategies, fits your specific situation.
Direct indexing is one of several approaches we use to help clients manage appreciated and concentrated stock positions. If you’re still weighing your options, our overview of 6 strategies to diversify a concentrated stock position walks through the full range of tools available, including direct indexing, Section 351 exchanges, exchange funds, and option-based strategies, along with the tax tradeoffs of each.
Frequently Asked Questions
What is direct indexing?
Direct indexing is an investment approach where an account directly purchases the individual stocks targeting an index or allocation amongst multiple indices, rather than holding a fund that tracks an index. This structure allows existing appreciated stock to be incorporated into the account and managed for ongoing tax loss harvesting.
What’s the minimum to start a direct indexing account?
Minimums vary by platform, but they’re often lower than what’s required for a Section 351 exchange, making direct indexing accessible to a broader range of investors.
Is direct indexing better than a Section 351 exchange?
Neither strategy is universally better. A 351 exchange requires a more diversified starting basket and higher minimum assets but converts the entire position tax-free into a new ETF in a single event. Direct indexing works with any range of appreciated stocks and provides ongoing tax loss harvesting opportunities.
Can I use direct indexing with just one stock?
Yes. Direct indexing can incorporate a single appreciated stock into the account, typically accompanied by a cash investment or many stocks, with or without cash funding.
Does direct indexing eliminate taxes on my appreciated stock?
No. Direct indexing does not eliminate taxes on the appreciated stock itself. Instead, it generates losses elsewhere in the portfolio that can be used to offset gains as the concentrated position is gradually sold down over time or to offset gains from other accounts.
If you are holding a concentrated position and are not sure where to start, the right first move is a conversation.
Click here to schedule a consultation with a Mason advisor >>
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Eric Rife, CFP®, CPWA®, is a Financial Planner at Mason Investment Advisory Services specializing in concentrated equity positions and executive compensation planning.
Thomas Pudner, CPA, CFA, CFP®, MST, is Co-Chief Investment Officer and Co-Director of Research at Mason Investment Advisory Services, where he has led investment research and portfolio strategy for 20 years.
This communication is for informational purposes and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Opinions and forward-looking statements expressed are subject to change without notice. Services are offered through Mason Investment Advisory Services, Inc. (“Mason”) an independent investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Mason, including our investment strategies, fees, and objectives, is included in the Form ADV Part 2, which is available upon request. This is not an offer or solicitation for investment advisory services.
Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns. There is no guarantee that any investment strategy discussed herein will work under all market conditions.
351 exchanges involve significant tax and investment risks that could result in substantial adverse consequences. Failure to meet the strict diversification tests will trigger full taxable recognition of gains. An investor will become a shareholder in the ETF with exposure to risks specific to that ETF and its objective. The transaction’s complexity requires specialized professional guidance, as errors in structuring or documentation can result in complete disqualification of intended tax benefits, significant penalties, and substantial unexpected tax liabilities.
Direct indexing is viewed as a hybrid form of investing that combines elements of both passive and active management. Clients need to be willing to accept benchmark-like potential returns as a starting point, with any customization of the portfolio possibly leading to a higher level of tracking error, which may lead to significant deviations from the benchmark return and has the potential to increase portfolio risk.
This disclosure does not constitute legal or tax advice – consult qualified tax and legal professionals before proceeding.
