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16 min read

Direct Indexes Are Great. Direct Index SMAs Are Bad.

Direct indexes outperform comparable ETFs on an aftertax expected basis. But direct index SMAs – separate subaccounts managed independently of the rest of the portfolio – are a bad way to implement them.



Direct indexes are great. They outperform comparable ETFs on an aftertax expected basis. But the industry-standard way of implementing direct indexes – with standalone Separately Managed Accounts (SMAs) – is bad. 

More precisely, it’s bad compared to the alternative of managing portfolios containing direct indexes holistically, without sleeves, subaccounts, or partitions. The holistic (sleeveless) approach supports higher after-tax, tracking-error-adjusted returns. It’s also simpler, less expensive and easier to work with – so easy that it makes working with direct indexes literally as easy as working with ETFs. 

Why the holistic (sleeveless) approach is simpler, less expensive and easier to work with

With a subaccount-based approach, allocating part of an account to a direct index requires opening and then funding a subaccount. Every time there is a cash in or cash out request, you have to calculate how much of the cash should be allocated to the direct index. And every time you wish to implement an asset-class rebalance, you need to figure out how much to invest in or take out of the direct index. 

If you have more than one direct index, you need to make sure there are no wash sale violations and no cross sales (simultaneous buying and selling of the same security) across the different direct indexes. If each direct index is managed in-house, some of this can be automated, but then you need to maintain a shadow accounting system to keep track of the subaccounts, which is an added expense and operational burden. 

With a holistic approach, all of this disappears. Choosing to use a direct index rather than an ETF for, say, large cap, is literally as simple as selecting the direct index option on a pull-down menu. And that’s…it. There is no shadow accounting system, no subaccount setup, no separate process for implementing a cash in, cash out, or asset class rebalancing.

Why the holistic (sleeveless) approach supports higher after-tax, tracking-error-adjusted returns

With the exception of optimal tax lot selection, tax management involves balancing low taxes and low risk (both absolute risk and relative risk, AKA tracking error, a measure of drift). But both tax and risk are properties of portfolios as a whole. Managing portfolios holistically lets you minimize risk for any given level of tax reduction, or maximize tax reduction for any given level of risk. Compared to a subaccount-based approach, you can usually win on both fronts.

We can make this more concrete by looking at the some examples:

  • Asset-class rebalancing. In a subaccount-based approach, rebalancing between asset classes involves selling down one subaccount and buying another, potentially involving hundreds of trades. This level of trading can be costly in both tax and transaction costs, which dictates that asset-class rebalancing be infrequent. If there is a target allocation of 70% large cap, you might not rebalance unless large cap falls below 60% or above 80%. But this means that, on average, you’ll have about 5% asset-class drift.

    In contrast, in a holistically managed account, you could, for example, rebalance your allocation to large cap when your large-cap holdings drift from 70% to just 69% or 71%. The reason is that if, for example, large cap is overweighted, there is no need to sell every large-cap stock, pro rata and buy every mid-cap stock, pro rata. Instead, you can:
    • choose to sell just a few stocks. In particular, you can preferentially sell those with the least appreciation, or possibly just those with losses.
    • narrow trades to those with the biggest impact on asset-class-level risk exposure. Little is gained by selling securities that, while technically large cap, are just above the threshold of mid cap, only to buy securities that are technically mid-cap securities, but just below the large-cap threshold. In order to minimize taxes, it’s better to sell “larger cap” large-cap stocks and buy “smaller cap” mid-cap stocks.
    • take advantage of every large-cap stock sale, even those primarily motivated by changes in the constituent securities of the large-cap model, as an opportunity to correct for your large-cap overweight (e.g. if you sold Ford to buy GM, some or all of the proceeds of the Ford sale could be used to buy mid-cap positions).

The difference is that the holistic approach lets you trade at the level of securities, not asset class. The result is superior portfolio management, one that enables you to simultaneously reduce taxes, turnover, expenses and drift.


  • Loss harvesting. Tax loss harvesting is the selling of a security not because you intrinsically want to get rid of it, but in order to realize a loss that can be used to lower your tax bill. When you harvest a loss, you typically try to invest the proceeds in a substitute security that is correlated with the one you just sold. In doing so, you’ll have more options if the portfolio is managed holistically. If, for example, you loss harvest Ford, the best substitute may be GM, regardless of whether GM happens to be found in the same subaccount as Ford. 

    But replacing the loss-harvested security with a correlated substitute is not always the best option. Instead, the better choice may be to use the funds generated by loss harvesting to purchase the most underweighted securities/sectors in the portfolio, regardless of their correlation to the loss-harvested security and regardless of whether they’re in the same asset class. This – and not simply finding the closest replacement – is what minimizes portfolio tracking error (drift). But you can only do this when the portfolio is managed holistically. In a subaccount-based approach, your only option is to reinvest “locally”, within the index itself.

  • Gains deferral. Gains deferral is the holding of an overweighted position in order to avoid realizing a gain. When you hold an overweighted position, the laws of mathematics dictate that something else in the portfolio must be underweighted. To minimize the tracking error impact of the overweighted position, you want to underweight the most correlated security or securities. When the overweighted holding is in a subaccount, you’re limited to underweighting some other security in the same subaccount. But with a holistically managed portfolio, you have the freedom to look across all holdings. 

    Suppose, for example, you use subaccounts, and there is an overweighted position in IBM in subaccount #1 that you’re holding to avoid realized capital gains (or you’re not selling simply because of a never sell constraint). The best option for managing risk would be to counterbalance the overweight in IBM by underweighting a correlated security like HP. But if HP is in, say, subaccount #2 and the subaccounts are rebalanced separately, this won’t happen. In contrast, with a holistic, subaccountless approach, there’s no barrier to this type of “cross subaccount” substitution, precisely because there are no subaccounts.

  • Index recomposition. Direct indexes are baskets of stocks that follow, well, an index. And when that index changes, the direct index (usually) changes as well. For example, when a mid-cap stock “graduates” from being a mid-cap stock to being a large-cap stock, it will be removed from the mid-cap index and added to the large-cap index. If the mid-cap direct index follows suit and sells the now-too-large stock, the investor will likely realize taxable capital gains. 

    In contrast, with a holistic approach, you can simply…not sell the holding. Yes, it’s now technically a large-cap rather than a mid-cap stock. But, from the perspective of tracking the combined mid- and large-cap indexes, this doesn’t matter. 


When it comes to direct indexing, holistic (sleeveless) is better than sleeved. But there’s really a deeper point: that direct indexes shouldn’t be viewed as a product at all; they should be viewed as a competence, the result of having the ability to scalably implement tax management and personalization across all portfolios, comprising any combination of mutual funds, ETFs, cash or individual equities. 

Once you have this ability, direct indexes stop requiring special processes. They’re no longer a “product”. They’re just something you do. Direct indexes are special in the sense that they will deliver higher after-tax expected returns. But, operationally, they shouldn’t be special at all.

President, Co-Founder