Direct indexing: Simplifying active tax management and customization

Progress is nothing new to asset management. When mutual funds gained popularity in the 1980s and 1990s, they changed the investment landscape by expanding participation in the markets. The new millennium brought exchange-traded funds (ETFs), which added transparency and tax efficiency in addition to accessibility. Direct indexing is the next step forward. With direct indexing, investors own individual stocks of an index, giving them more control to customize and proactively manage their tax liabilities. As our world becomes more personalized – with tailored ads, digital assistants, and custom news feeds – the expectation for investing to become personalized grows as well. How can investors get more of what matters most to them? The ask now is not just for an accessible way to participate in the markets, but a customized one that applies active tax management to meet their tax needs.

Technology now enables the delivery of this personalized approach at scale. By utilizing a separately managed account (SMA) vehicle, direct indexing allows advisors to customize portfolios to meet unique client needs, and seek to deliver tax benefits through more robust tax-loss harvesting using technology. This means investors can get more from what they own. Because of these benefits, direct indexing is becoming increasingly popular and is expected to be one of the fastest growing segments of the investment management landscape. Per a 2022 study by Cerulli Associates, a research and consulting firm specializing in asset management and distribution trends worldwide, direct indexing assets are projected to grow at a 5-year compound annual growth rate (CAGR) of 12.3%, which would nearly double assets under. This is even greater than the pace of other fast-growing areas such as ETFs, expected to grow at a 9.5% CAGR.*

The benefits of direct indexing: Tax management and customization

When households with greater than $5 million in investable assets shared what they needed most in that same Cerulli study, tax management was number one on their list. Despite households reporting this as highly important, 70% of “tax-managed” assets are not managed systematically, but rather, in an ad hoc manner.* When done manually, tax-loss harvesting is typically considered only during periods of extreme volatility or at the end of the year. By leveraging the use of technology, direct indexing allows advisors to potentially lower their clients’ tax bills in two important ways: through (1) tax-managed transitions of existing portfolios or concentrated stock positions and (2) active, ongoing tax-loss harvesting – both of which mitigate the burden of taxes over time. Advisors not applying this form of active tax management may be leaving tax benefits – a high priority for clients – on the table.

Along with active tax management, direct indexing allows for personalization in a way that ETFs and mutuals funds don’t. Investors can personalize a direct indexing SMA to their tax situations, investment needs or values. For example, an executive who has a large position in a single stock may find the ability to restrict this holding or its specific sector from the SMA to diversify away from it in a tax-efficient manner, especially valuable in reducing concentration risk. This ability to personalize is another factor highly valued by investors. Households across all wealth levels reported this as their number one ask.*

Direct indexing makes delivering potential tax benefits easy

Direct indexing tracks an index by holding individual securities directly within a sclient’s SMA. This is typically done by owning a subset of holdings. For example, using 350 stocks within the S&P 500 that still provide returns similar to the index.

Owning individual securities rather than an ETF or mutual fund gives investors more control. With tax-loss harvesting, each holding can be reviewed for a potential loss event when it drops below a certain threshold. Because a subset of holdings is being used, there is flexibility to move in and out of positions as opportunities in the market arise. When leveraging the latest technology, this review can be accomplished on a daily or monthly basis, providing tax benefits throughout the year. Advisors save time and manual work by outsourcing and automating this process, while also delivering more of what is most important to their clients: tax benefits.

In the following example, an investor faces $100,000 in capital gains (an approximate tax bill of $23,800) and invests in a direct indexing SMA. By harvesting losses within the SMA, investors can offset gains and potentially lower their tax bills. 

Direct indexing may also provide value when transitioning out of a portfolio or concentrated position with unrealized gains. It offers an alternative solution to selling the entire portfolio or position at a gain and generating a tax bill for the full amount. With a technology-driven solution, a client can set a maximum tax budget and use an automated approach to sell down the exposure within budget. This process slowly sells off a portion of the gains when there are losses available to offset them, minimizing the tax liability. As the position is sold off, it transitions to the index-based strategy as illustrated in the following example. 

Direct indexing can help set you apart

By leveraging direct index SMAs, advisors can differentiate their practice in a world where clients have many options. Direct indexing should be considered for:

• Clients who need a strategy for ongoing tax management
• Clients who want to transition concentrated positions into a diversified portfolio while minimizing capital gains taxes
• Advisors who are onboarding new clients and need to transition their legacy portfolios in a tax-managed way
• Clients who want to make charitable contributions in a tax-efficient way
• Clients who are looking to customize their portfolios based on their individual investment needs or personal values

 Direct indexing at J.P. Morgan: The Tax-Smart platform

At J.P. Morgan Asset Management, we recognize that it’s not just what clients earn that matters; it’s what they keep. Tax management plays a critical role in wealth management, but dedicating the time needed to do it effectively can be difficult – and nearly impossible – to do at scale for the portfolios you manage – until now.

J.P. Morgan’s Tax-Smart Platform can help minimize clients’ tax bills to maximize their outcomes and save you time – so you can focus more on growing your practice to its fullest potential. Our intelligent tax technology offers continual tax analysis and effortless tax-loss harvesting – requiring no daily management and no manual monitoring – and simplifies portfolio transitions. Oversight from a seasoned J.P. Morgan Asset Management portfolio manager may also help prioritize long-term investment gains in addition to tax benefits. And, because our platform offers model portfolios, indexed SMAs and active SMAs, you have more tailored solutions available to better serve your current clients and a broader pool of prospects.

J.P. Morgan’s Tax-Smart Platform means effortless tax management, potential enhanced client outcomes and expanded opportunity.