Direct indexing is the financial industry's equivalent of a green juice cleanse: it sounds virtuous, everyone's doing it, and almost nobody stops to ask whether it's actually working.
Let's just say, direct indexing is having a moment.
The basic idea sounds appealing: Instead of owning an index fund, you own many of the individual stocks that make up the index. Why does that matter? Because even when an index such as the S&P 500 is having a perfectly good day, plenty of the stocks inside it may not be. Direct indexing allows the manager to go looking for those individual losers, sell them to capture capital losses, and replace them with similar investments.
Finding more losers is not usually an investment strategy's best sales pitch, but in this case, it's the whole point.
Those harvested losses can then be used to offset capital gains elsewhere, potentially creating what the investment industry likes to call "tax alpha": additional value produced through more tax-efficient management.
It is a perfectly legitimate strategy, and as someone who has spent her entire career and thousands of hours helping clients mitigate their tax liability, I believe that, in the right circumstances, it can also be an excellent one.
But I also think that a large amount of harvested losses is not necessarily the same thing as tax alpha.
Yes, I Said That a Harvested Loss Is Not Automatically Tax Alpha
I know this may ruffle some feathers, but as my GenZ children would say, "hear me out"!
Oftentimes, when the concept of direct-indexing accounts is raised, the conversation focuses heavily on generating losses and considerably less on what those losses actually accomplish, what the strategy costs, and how the investor will eventually get out.
Which, I'm going to say loudly for those in the back, are the questions that need to be answered to determine if this strategy will produce actual tax alpha for a particular investor.
For example, imagine that a direct-indexing account buys a stock for $100,000. Its value falls to $80,000, so the manager sells it, captures a $20,000 capital loss, and reinvests the $80,000 in a similar, but not substantially identical, stock.
The client now has a $20,000 capital loss.
But the client's cost basis in the new stock is also reduced by the $20,000, meaning the new stock's basis is only $80,000 rather than the original $100,000. In other words, the strategy accelerated capital losses today, with the tradeoff being potentially larger capital gains later.
That absolutely doesn't mean the strategy has no value; deferring a current tax liability can be incredibly impactful. But generating a capital loss does not, by itself, improve the client's balance sheet. It adds a tax asset on one side while the lower basis creates the potential for an offsetting tax liability on the other.
True tax alpha exists only if that opportunity ultimately produces an after-tax benefit after considering the reduced basis, future gains, additional fees, and added complexity created along the way.
Simply realizing a loss is not tax alpha. It is the opening move in a strategy whose value depends on everything that happens afterward.
The Loss Is Only as Valuable as What You Do with It
Capital losses can be incredibly useful when they offset gains a client was already expecting to recognize.
A client may be selling a business, a vacation home, or a concentrated position in company stock. Maybe the client is approaching retirement and wants to reallocate her appreciated portfolio but minimize the tax consequences. In those cases, harvested losses can reduce a tax liability in a meaningful and measurable way.
But without a larger strategy, losses often get used simply because they are available.
Perhaps they offset gains created by a relatively minor portfolio adjustment. Perhaps they accumulate for years with no identified use at all. Or perhaps everyone is simply pleased to see a very large negative number on Schedule D.
Which, as far as I can tell, is the only context in which financial professionals get genuinely excited about losing money.
Using a loss to facilitate routine rebalancing is not inherently bad, and it may produce real portfolio and tax benefits. But it is fair to ask whether that benefit was meaningful enough to justify the additional fee, complexity, and future low-basis positions created by the strategy.
The right question is not, "How much did we harvest?" It is, "What did those losses allow us to accomplish?"
If the answer is vague, the strategy may be generating more activity than value.
The Easy Solutions Are Not Always So Easy
Supporters of direct indexing often point out that future gains might be recognized in a lower-tax year, eliminated through a basis adjustment at death, or avoided by donating the appreciated stock to charity.
All of those outcomes are possible. But even those seemingly simple solutions can become more complicated in a direct-indexing account.
Most investors are not using direct indexing to assemble a collection of stocks they independently wanted to own. They are using those stocks collectively to replicate an allocation that might otherwise have been held in an index fund. That distinction matters.
Donating one of the appreciated stocks removes a piece of the overall allocation. The manager may then need to replace it with cash or adjust other holdings to keep the portfolio aligned, potentially creating additional trades and tax consequences.
That may be perfectly manageable when the amounts are small. Across hundreds of positions accumulated over several years, it can become a much larger constraint.
Likewise, holding low-basis stocks until death may produce a favorable tax result, but it also means letting the tax strategy dictate the investment strategy for the rest of the client's life, and limiting the client's ability to actually sell the positions and use the funds for a different purpose. Positions that no longer fit may remain in the portfolio simply because selling them would generate gains.
The client began with a strategy intended to create more tax flexibility. Over time, it may leave the client with less flexibility instead.
Tax Alpha Often Declines Over Time
Direct indexing often produces its most noticeable harvesting opportunities in the early years, since a new account's holdings have only just established cost basis. Market volatility may quickly push some of them below that basis, creating losses that can be harvested.
Over time, especially during a rising market, more holdings develop substantial unrealized gains. The obvious harvesting opportunities become less plentiful. New contributions and future volatility can create additional losses, but an older account may generate considerably less tax value than it did during its first few years.
Can you guess what generally does not decrease along with the harvesting opportunities? If you picked "the fee," you can give yourself ten points and a pat on the back!
Again, that doesn't automatically make the strategy inappropriate. But it does mean the additional cost needs to be periodically compared against the tax benefit the account is currently producing, rather than continuing to justify the fee using results from its early and most productive years.
Because you know what reduces tax alpha? An ongoing fee with the only benefit being a historical list of losses.
Then There Is the Small Matter of Getting Out
This is the part I find most concerning: many direct-indexing strategies do not appear to have an exit plan.
A client begins with what could have been one clean, low-cost index fund: easy to understand its place in the portfolio, easy to benchmark against expected returns, easy to quantify the impact of selling to fund a family trip around the world.
A few years later, the account contains hundreds of individual stocks, each with its own cost basis, unrealized gain, and eventual tax consequences.
A well-constructed direct index may still be broadly diversified. But harvesting, customization, and tax constraints can cause it to drift from the index it was intended to track. Some stocks may become significantly overweight or underweight, while low-basis positions can become increasingly difficult to sell.
The client may eventually decide that the additional fee is no longer worthwhile, only to discover that exiting the strategy entirely could trigger substantial gains, or result in reduced flexibility and increased portfolio drift in order to avoid them.
So the account continues, and the client ends up paying a fee to maintain the complexity created by the strategy, because exiting the strategy has itself become complicated.
When Direct Indexing Can Earn Its Keep
None of this means direct indexing is a bad tool. It means it is a specialized tool that is sometimes marketed as a universal solution. It can be particularly valuable in a few circumstances.
· Gradually diversifying a concentrated stock position
A client may hold a large, low-basis position in an employer's stock, an inherited investment, or another legacy holding. Losses generated elsewhere in a direct-indexing account can help offset gains as that position is sold over time.
That is a deliberate strategy with a measurable goal: reduce the concentrated position and create a more diversified portfolio.
Just as importantly, it has a logical endpoint.
· Offsetting a significant expected gain
A business sale, the sale of a vacation or investment property, or another liquidity event may generate a substantial capital gain. If direct indexing is implemented early enough and the market provides harvesting opportunities, the resulting losses may reduce the tax associated with that event.
Here, the loss has a defined job before it is ever created.
· Managing taxes during a life transition
Income, filing status, and tax rates can shift significantly during divorce, widowhood, retirement, or a career change.
I've sat across the table from enough women mid-transition to know that the tax code does not pause for grief, and it does not pause for a fresh start, either.
For many of the women I work with, those transitions create a limited window in which the timing of gains and losses can matter considerably. Direct indexing may be useful when it is coordinated with the client's investment plan, cash-flow needs, estate plan, and expected tax situation.
The important words are "coordinated" and "expected."
Tax harvesting in isolation is activity. Tax harvesting connected to an actual financial objective is strategy.
The Questions Worth Asking
If you already have a direct-indexing account, or an advisor is recommending one, consider asking:
• What specific gains are these losses expected to offset?
• How will generating the losses affect the basis of my portfolio?
• Are we primarily eliminating tax or deferring it?
• What assumptions are we making about my future capital-gains rate?
• How much extra am I paying for the strategy?
• Is the account still producing enough value to justify that fee?
• How closely does it still track the intended allocation?
• How will charitable gifts or other withdrawals affect that allocation?
• Under what circumstances would we stop using the strategy?
• What is the eventual plan for unwinding or simplifying the portfolio?
Good answers should connect the strategy to a specific tax issue, investment objective, or life event. They should also acknowledge the cost, the reduced basis, the investment constraints, and the eventual exit.
If the answers amount to "We harvested a lot of losses" and "We plan to keep doing this forever," that is worth examining more closely.
Direct indexing is not the problem. Neither is tax-loss harvesting.
The problem is treating every harvested loss as tax alpha without asking whether it created any meaningful after-tax value.
Without an intentional use for the losses, regular measurement of the benefit, and a thoughtful way out, the promised tax alpha may turn out to be little more than tax complexity with a very good marketing department.
You don't need to overhaul anything today. You just need someone asking these questions on your behalf, sooner rather than later. If that's not happening right now, let's talk.
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Susan Jones and Sara Gelsheimer are investment advisor representatives registered with Savvy Advisors, Inc. (“Savvy”). All investment advisory services offered by Susan Jones and Sara Gelsheimer are offered through Savvy. Sorelle Wealth Partners is an independent marketing brand name used by Susan Jones and Sara Gelsheimer for advertising and marketing purposes only. Sorelle Wealth Partners and Savvy are not related or affiliated. For more information about Savvy, please visit our website.