With Direct Indexing, Optimization Techniques Matter
In this paper, the Allspring Custom SMA team explores why not all direct indexing strategies are managed the same way. See how optimizing daily for both tax savings and index tracking may lead to better after-tax outcomes for investors.
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Key takeaways
- Management approach makes a difference: How a direct indexing portfolio is run can vary significantly from one provider to the next, and those differences can affect your results.
- Optimization shapes your outcomes: Different approaches to optimization can have a material impact on your holdings, your tracking error, and ultimately your after-tax return.
- Daily, holistic optimization can help: Allspring optimizes portfolios daily for both tax-loss opportunities and tracking error, aiming for a more tax-efficient, index-aligned experience.
Executive summary
What direct indexing is—and why management matters
Direct indexing lets you own the individual stocks that make up an index in a separately managed account (SMA), rather than through a fund. That structure opens the door to personalization and year-round tax management. But how the portfolio is managed behind the scenes can make a meaningful difference in your results.
The limits of a “triggered” approach
Some providers use a “triggered” approach to tax-loss harvesting, acting only when specific conditions are met, such as available losses in a tax lot. The drawback is that this can capture losses while overlooking their effect on tracking error, the measure of how closely your portfolio follows its index. The result may be added drift and unintended risk.
How daily, holistic optimization can help
Allspring evaluates both tax-loss opportunities and tracking error together as part of a daily optimization process. We assess not only whether a loss is available, but whether acting on it makes sense given its impact on tracking error and the goals of the account. We don’t trade every day, but having these insights daily supports smarter, more disciplined decisions.
A tailored experience for each investor
Investors can emphasize different priorities: minimizing tracking error to more closely mirror the index, prioritizing tax savings, or striking a balance between the two. Our proprietary optimization process is built to tailor that tradeoff. And our portfolio managers apply real-world judgment on when, where, and how to adjust portfolios over time.
Important considerations
Direct indexing can be a powerful way to pursue index-like returns with added personalization and tax management. But the value it delivers depends heavily on how the portfolio is optimized day to day. Understanding a provider’s approach—and how it balances tax savings with tracking error—can help you choose a strategy suited to your goals.
Common questions about direct indexing optimization
- What is direct indexing?
Direct indexing is a strategy that seeks to track an index by owning its individual stocks directly in a separately managed account (SMA), rather than through a mutual fund or exchange-traded fund (ETF). Because you own the underlying stocks, you can personalize the portfolio and manage taxes throughout the year.
- How is direct indexing different from an index fund or ETF?
An index fund or ETF holds the index for you in a pooled vehicle, so you own fund shares rather than the underlying stocks. With direct indexing, you own the individual stocks in your own account, which allows for tax-loss harvesting at the individual-security level and greater customization.
- How does tax-loss harvesting work in my direct indexing portfolio?
Tax-loss harvesting means selling an investment that has dropped in value so the realized loss can help offset taxes owed on other gains. Because a direct indexing portfolio holds individual stocks, it can create more opportunities to harvest losses while keeping the portfolio aligned with its index.
- What is tracking error, and why should I care about it?
Tracking error measures how closely your portfolio follows its target index. Lower tracking error means it stays more in line with the index; higher tracking error means it may drift and behave differently than you expected. Managing it is central to a well-run direct indexing portfolio.
- Why does my provider’s optimization approach matter?
How a provider optimizes determines whether tax-loss harvesting quietly adds risk to your portfolio. An approach that chases losses without weighing tracking error can pull your portfolio away from its index. Evaluating taxes and tracking error together aims to capture tax benefits without sacrificing how closely the portfolio tracks.
- How does Allspring approach direct indexing optimization?
Allspring optimizes portfolios daily, evaluating tax-loss opportunities and tracking error at the same time. Our process flags not just available losses but whether acting on them makes sense for your account, and our portfolio managers apply discretion on when to trade—aiming for a more tax-efficient, better-tracked result.
Related insights
Explore the ins and outs of direct indexing, why it matters, and how it can be used to create personalized, tax-smart investment strategies.
All investing involves risks, including the possible loss of principal. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held in the portfolio. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the portfolio can be sudden and unpredictable. A portion of the strategy’s income may be subject to federal, state, and/or local income taxes or the alternative minimum tax. Any capital gains distributions may be taxable. Bond laddering does not ensure a profit or protect against loss in a declining market. Foreign investments may be subject to lower liquidity; greater price volatility; and risks related to adverse political, regulatory, market, or economic developments and may be affected by changes in foreign currency exchange rates. The use of derivatives may reduce returns and/or increase volatility. Style factor exposure, including but not limited to beta, growth, value, liquidity, etc., can perform differently and shift in and out of favor through a market cycle.
Investors should know that this strategy deployed may be subject to additional investment risks. For important information about the investment manager, please refer to the investment manager’s Form ADV Part 2, which is available upon request.
Allspring Managed Account Services (the firm) is a unit within Allspring Global Investments and is responsible for the management and administration of the Allspring Funds Management, LLC, retail separately managed account portfolios (wrap portfolios). Allspring Funds Management acts as a discretionary manager for separately managed accounts ("SMA") and as a non-discretionary model provider in a variety of managed account or wrap fee programs (“MA Programs”) sponsored by third-party investment advisers, broker-dealers, or other financial services firms (a “Sponsor”). When acting as non-discretionary model provider, Allspring Funds Management's responsibility is limited to providing non-discretionary investment recommendations (in the form of model portfolios) to the Sponsor. The Sponsor may use these recommendations in connection with its management of MA Program accounts. In these “model-based” programs, the Sponsor serves as the investment manager and maintains trade implementation responsibility.
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