The Tax Alpha: Direct Indexing
The Tax Alpha: Direct Indexing
Why buy the ETF when you can buy the ingredients? Unbundling the S&P 500 to harvest losses daily and boost after-tax returns by 1-2%.
Executive Summary
- Unbundling the Index: Instead of buying one share of SPY (S&P 500 ETF), a computer algorithm buys all ~500 individual stocks for you. This gives you granular control over the underlying assets.
- Continuous Tax Loss Harvesting: Even when the S&P 500 is up +10%, roughly 150 stocks inside it might be down. The algorithm automatically sells these losers to realize a tax loss (offsetting other gains) and immediately buys a substitute stock to maintain tracking.
- Customization (ESG/Factor): Since you own the shares directly, you can exclude specific companies (e.g., “No Tobacco”, “No Oil”) or overweight factors (e.g., “More Quality”)—something impossible with a standard ETF.
The Wash Sale Compass
Complexity Warning: To avoid the “Wash Sale Rule” (buying back the same stock within 30 days), the algorithm must buy a correlated substitute (e.g., Sell Coke, Buy Pepsi). This requires sophisticated software. Doing this manually for 500 stocks is impossible.
Mechanic: Extracting Tax Alpha
+1.5% Alpha
Tax Savings
Granular
Own 500 Stocks
Bespoke
Exclude Bad Cos
Auto-Pilot
Algorithmic
Simulation: ETF vs. Direct Indexing ($5M Portfolio)
After-Tax Wealth Accumulation (10 Years)
| Feature | Mutual Fund / ETF | Direct Indexing (SMA) |
|---|---|---|
| Ownership | You own a fund share | You own individual stocks |
| Loss Harvesting | None (Inside the fund) | Daily/Weekly Scanning |
| Minimums | $1 (Fractional) | Typically $250k+ |
“Direct Indexing turns volatility into an asset. The more volatile the market, the more opportunities there are to harvest losses, essentially letting the IRS subsidize your portfolio risk.
Essential Resources
INTERNAL
BMT Playbooks