Direct Indexing FAQ

Many investors and advisors are already familiar with index ETFs (Exchange-Traded Funds) and index mutual funds as ways of getting exposure to broad market indexes. But investors who want to track the performance of an index like the S&P 500® can also own a subset of the stocks in that index rather than owning all 500 or so. And they can do so in a separately managed account. A separately managed account structure gives direct indexing, tax management and customization advantages not typically available in pooled index investments like index ETFs or index mutual funds.

By matching the risk characteristics and performance attributes of the index in a process called optimization, direct index portfolios can achieve pretax performance similar to their benchmarks without having to own all of the stocks in that benchmark.

Investors can tailor the content of direct indexed, separately managed accounts to reflect their beliefs and values or limit exposure to stocks or sectors they want or need to avoid – while pooled index investments like ETFs and index mutual funds must be entered or exited in cash, which may result in capital gains taxes.

Direct index SMAs (Separately Managed Accounts) can accept contributions and withdrawals in-kind, meaning that an investor contributes or withdraws shares of stock without automatically incurring taxes in that transaction. Direct index SMAs also offer individualized tax treatment that isn't available in pooled vehicles like ETFs and index mutual funds.

Owning the individual stocks allows the portfolio manager some control over each investors' cost basis, which means that managers may be able to control the realization of gains and losses for the investors' benefit. Portfolio managers can manage by individual tax lot, which means that they can choose when to realize a gain or loss – short term or long term; and how much gain or loss to realize.

Selectively, harvesting tax losses provides a tax benefit, either by offsetting taxable gains elsewhere in the investor's portfolio or shielding some ordinary income from taxation. Unused tax losses can also be carried forward in time to offset future taxable gains. In a typical year, the tax benefit from tax loss harvesting is likely to be greater than the management fee associated with the direct index SMA.

VAST™ direct index SMAs are managed to the unique tax situation of each investor, which means that every taxable portfolio is managed uniquely. Investors can exclude individual stocks, sectors, industries or business involvement as a percent of a company's revenue. Investors can incorporate tax management into life cycle events, such as in-kind charitable donations of highly appreciated stock or tax efficient cash withdrawals to fund major purchases.

In many cases, direct indexed, Separately Managed Accounts may be available at a cost that's comparable to ETF fees. Although direct index SMAs may experience more frequent trading and more small trades than other strategies, the costs associated with those trades are typically included in the regular asset based fee an investor pays. That fee would be the same whether the account trades a little or a lot.

Managing multiple investment types as sleeves together in an account can help align the various risk exposures of the portfolio to those of the selected asset allocation. Managing multiple investment sleeves in a single account gives the portfolio manager the flexibility to make tax optimal trades on each investors behalf transparently and with minimal investor involvement. And asset allocation changes can be made more tax efficiently when a single portfolio manager controls the trading.

An investor who doesn't need customization or tax management probably doesn't need a direct index separately managed account. A carefully chosen ETF will probably provide adequate index exposure for that investor. Also, investors in lower tax brackets will not see the same tax advantages as investors in higher tax brackets because realized tax losses in the portfolio will be offset in capital gains that are taxed at a lower rate.

A direct index SMA that generates tax losses works best as part of a portfolio of different investments that generate taxable gains so that the direct index tax losses can offset gains elsewhere in the portfolio.

Passive and active strategies can live well alongside each other in a portfolio. Passive makes a great core or evergreen holding in a fairly constant weight within the portfolio, whereas active strategies may make better tactical allocations when they're in favor. Most active strategies are managed without regard to their tax impact on individual investors, so pairing them with tax-managed passive direct indexing can improve each investors overall tax outcomes. The tax efficiency of a passive allocation to one or more direct index separately managed accounts can produce tax losses that help to offset gains realized within active strategies or when changing from one active strategy to another.