Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Direct Indexing for Tax Alpha
Transcript
- Lucas: So you've heard of index funds. You've probably heard of ESG screening. But there's a strategy quietly taking over wealth management that combines both and adds a tax twist — it's called direct indexing, and family offices are adopting it faster than almost any other product right now. Luna: Direct indexing — that's where instead of buying an S&P 500 ETF, you actually own the 500 stocks individually, right? Lucas: Exactly. You're not buying a share of a fund that holds Apple and Microsoft. You buy Apple and Microsoft directly. And the reason families with, say, five million dollars or more are doing this is that it unlocks something called tax alpha — the ability to harvest losses at the individual stock level in a way an ETF simply can't. Luna: I'm already thinking about the paperwork. But I know the software has gotten good enough that it's automated. Before we go deep — if this episode is giving you a new angle on your portfolio, the way these stay ad-free is listener support. You can find us at buy me a coffee dot com slash fexingo. That's a small way to keep the conversation going. Lucas: Appreciate that. And yeah, the automation is the key. Twenty years ago, direct indexing was only for the ultra-wealthy with a dedicated team rebalancing manually. Now platforms like Parametric, Aperio, and even Schwab's direct indexing service handle the rebalancing and tax loss harvesting algorithmically. Luna: So how does the tax alpha actually work? Give me a concrete example. Lucas: Sure. Let's say you're tracking the S&P 500 with a five million dollar direct indexed portfolio. In a normal year, some stocks go up and some go down. Suppose Apple drops 10 percent because of a supply chain scare, and you bought it at $150 and now it's at $135. The algorithm sells that position, realizes the loss, and immediately buys a similar but not 'substantially identical' stock — maybe Microsoft or a tech ETF — to keep your market exposure. Luna: And that loss offsets gains elsewhere in the portfolio, or even ordinary income up to three thousand dollars a year. Lucas: Right. And the beauty is you can do this dozens or even hundreds of times a year across the portfolio. Wealth management studies show that tax alpha from direct indexing typically adds 1 to 2 percent annually after fees, compared to a plain ETF. For a five million dollar portfolio, that's fifty to a hundred thousand dollars a year in tax savings. Luna: That's significant. But isn't there a risk of wash sales if the algorithm isn't careful? Lucas: Absolutely. The wash sale rule says you can't claim a loss if you buy a substantially identical security within 30 days before or after the sale. So the algorithms have to avoid buying back the exact same stock. That's why they replace Apple with Microsoft or with a sector ETF. The IRS has never explicitly defined 'substantially identical' for stocks in different companies, so advisors generally treat different tickers as safe. Luna: What about the cost? I've heard direct indexing has higher fees than an ETF. Lucas: It does. A typical S&P 500 ETF charges maybe 3 basis points. A direct indexing account might run 20 to 40 basis points, plus trading costs. But for a portfolio where you're realizing tax savings of 100 basis points or more, the net benefit is still positive. The breakeven is usually around one million dollars — below that, the fees eat up too much of the tax alpha. Luna: So it's not for someone with a fifty thousand dollar 401k. But for the high net worth families you cover, it makes sense. Lucas: Exactly. And there's another layer: customization. A family might want to exclude tobacco stocks or overweight clean energy. With direct indexing, you can set those constraints and the algorithm will still track the index as closely as possible while implementing your values. Luna: I've also heard that direct indexing is useful for concentrated stock positions — someone who inherited a bunch of a single stock and wants to diversify without a massive tax hit. Lucas: That's a huge use case. Say you inherited two million dollars worth of Berkshire Hathaway — good problem to have — but your cost basis is very low. If you sell it all, you'll owe capital gains tax. With direct indexing, you could sell a portion each year, realize gains only up to the amount you can offset with harvested losses from the rest of the portfolio. Over time you can unwind the concentration tax efficiently. Luna: So you're using losses from the diversified part to offset gains from the concentrated part. That's clever. Lucas: It's exactly what family offices are doing. And the data backs it up. A Cerulli Associates report from late 2025 found that direct indexing assets under management hit $800 billion, up from about $350 billion in 2022. They project it'll pass two trillion by 2029. Luna: That's fast growth. But is there a downside? Besides the higher fees. Lucas: The main downside is complexity. If you're not working with a good advisor or platform, you could end up with tracking error — meaning your portfolio drifts away from the index. Also, if you ever want to leave the direct indexing platform, you're left with a portfolio of 500 individual stocks that you'd have to manage or sell, potentially realizing gains. Luna: So you're essentially locked in unless you want to pay taxes. Lucas: Right. It's a commitment. But for families who plan to hold the portfolio for ten, twenty, thirty years, the compounding of tax alpha is enormous. One wealth manager I spoke to calculated that a three million dollar direct indexed portfolio over twenty years, assuming 8 percent gross return and 1 percent tax alpha, would end up about nine hundred thousand dollars ahead of the ETF version after taxes. Luna: Almost a million dollars just from tax efficiency. That's hard to ignore. Lucas: And it's not just S&P 500. You can direct index the Russell 1000, the MSCI EAFE for international, even custom indices. Some families are doing this with bond portfolios too, though that's more niche. Luna: What about the minimum account size? You mentioned one million as the breakeven, but what do most platforms require? Lucas: Most institutional platforms like Parametric start at one to two million. Some robo-advisors like Wealthfront have a direct indexing product with a minimum of five hundred thousand. And Schwab's product, which launched in 2023, has a minimum of one hundred thousand but only for the S&P 500 and only for certain account types. Luna: So it's trickling down to smaller investors, but still primarily for the affluent. Lucas: Exactly. And I think we'll see minimums continue to drop as technology gets cheaper. But for now, the sweet spot is the high net worth family with a long time horizon and a desire for both tax efficiency and customization. Luna: One question I have — how does direct indexing handle dividends? If you own the stocks individually, you get dividends from each company, but you also have to track them for tax purposes. Lucas: That's a good point. The platform handles dividend tracking automatically. You receive dividends just like you would if you owned the stocks in a regular brokerage account. They're reported on a 1099-DIV at year end. The tax alpha comes from capital loss harvesting, not from dividend treatment. Luna: So no special magic with dividends. Got it. Lucas: Right. The magic is purely in the harvesting. And one more nuance: if you're in a state with high income tax, like California or New York, the benefit is even larger because you're offsetting state taxes too. Luna: Good to know. So for a family office client in California, direct indexing could be a no-brainer. Lucas: Absolutely. And we're seeing that reflected in the growth numbers. The wealth management arms of large banks — JPMorgan, Goldman, Morgan Stanley — are all rolling out direct indexing capabilities for their private wealth clients. It's become a competitive necessity. Luna: I'm curious — are there any scenarios where direct indexing doesn't make sense? For example, if someone has a very low cost basis in the index itself? Lucas: That's actually a common situation. If you've held an ETF for years and it's appreciated significantly, selling it to switch to direct indexing would trigger a large capital gain. In that case, it might not be worth it unless you have losses elsewhere to offset. Some advisors recommend starting direct indexing with new money rather than switching an existing position. Luna: So you dollar-cost average into the direct indexed portfolio over time. Lucas: Exactly. Or you can gift the appreciated ETF to a donor-advised fund or charity, and use the cash you would have donated to start the direct indexing. That's a common strategy among ultra-wealthy families. Luna: And we covered donor-advised funds in episode 30, so listeners can check that out. Lucas: Right. So to wrap up: direct indexing is essentially a tax optimization wrapper around passive investing. It's not for everyone, but for high net worth families with long horizons, the combination of tax alpha, customization, and concentration management makes it one of the most powerful tools in the wealth manager's toolkit. Luna: And the software has made it accessible enough that it's no longer just for the ultra ultra wealthy. If you have a million dollars to invest, it's worth a conversation with your advisor. Lucas: Absolutely. And I'd add that if you're listening and thinking about this for your own portfolio, make sure you understand the lock-in risk and the fee structure. It's a strategy that rewards patience and a long time horizon. Luna: Good advice. Thanks, Lucas. Lucas: Thanks, Luna. And thanks to our listeners for joining.