When Direct Indexing Matures: What Investors Should Do Next

Over the past several years, direct indexing has moved from a niche strategy used by ultra-high-net-worth investors into a more widely adopted investment portfolio tool. The appeal has been relatively straightforward: diversification similar to an index fund, combined with the ability to harvest tax losses at the individual security level.

For many investors, the strategy has delivered exactly what it promised. During periods of volatility, particularly in the early years of a direct indexing portfolio, tax loss harvesting can generate meaningful capital losses that can be used to offset gains elsewhere on the balance sheet. But as more investors reach the five- to seven-year mark in their direct indexing programs, a common question emerges: what happens when the strategy runs out of losses to harvest?

The reality is that when direct indexing strategies mature, the tax alpha can begin to decline.

The effectiveness of direct indexing largely depends on dispersion within the index. When individual securities move differently from one another, even if the index overall rises, investors can harvest losses in lagging positions while maintaining similar market exposure through replacements.

In the early years of a direct indexing portfolio, the opportunities for harvesting losses are often plentiful. Markets fluctuate, individual securities fall in and out of favor, and portfolios contain many positions with tax losses below cost. Investors can systematically harvest those losses while reinvesting in similar securities to maintain index exposure. These harvested losses accumulate as valuable tax assets. They can offset realized capital gains elsewhere in a portfolio, reduce tax liability, and in some cases be carried forward to future years.

But this benefit has a lifecycle.

As time passes, two things happen inside a direct indexing portfolio. First, markets tend to rise over the long term. Many of the underlying holdings accumulate significant unrealized gains. Positions that once provided tax harvesting opportunities can become highly appreciated assets.

Second, repeated harvesting gradually resets the cost basis of the portfolio. After several years of harvesting losses and reinvesting at lower prices, there are simply fewer remaining opportunities to realize new losses.

The result is a portfolio that still tracks the index but produces fewer tax losses each year. The strategy that once generated meaningful tax alpha begins to deliver diminishing returns.

One option some investors consider is “resetting” the portfolio, or selling appreciated holdings and starting the strategy over with a fresh cost basis. While this may restore harvesting opportunities, it often triggers significant realized gains in the process. In many cases, the tax cost of resetting outweighs the future tax benefits.

Another alternative is adding cash, or “fresh basis,” to the strategy. While this provides new capital to diversify and create potential loss harvesting opportunities, many investors simply don’t have ample cash to invest nor want to feel obligated to add cash for the strategy to simply work as originally intended.

Instead, investors are often left holding the direct indexing strategy indefinitely but without the original advantages. This may continue to provide diversification and marginal tax benefits, but the portfolio increasingly becomes challenging to rebalance without incurring capital gains.

A more thoughtful approach is to ask whether other strategies might now be better suited to generating tax efficiency and portfolio diversification.

One strategy that deserves increasing attention for investors with mature direct indexing portfolios is long/short investing.

Modern long/short strategies are not simply about picking long winners and short losers. Instead, some are designed as benchmark-aware extensions of core equity exposure, where long and short positions are actively managed to generate incremental alpha while maintaining tight tracking error to an index such as the S&P 500.

For example, a mature direct indexing portfolio might achieve 2-3 percent annually in realized tax loss harvesting. However, by refreshing that portfolio in a 130/30 long/short strategy, the tax loss harvesting potential can increase materially, in some cases approaching 10 percent per year.

From a tax perspective, long/short strategies can create a more consistent stream of realized losses through the management of short positions and active trading. These losses can help offset gains from long positions or other investments in a portfolio, such as concentrated stock holdings.

This dynamic can restore a form of tax alpha that mature direct indexing portfolios struggle to produce.

In other words, while direct indexing can often generates tax benefits primarily through market volatility, long/short strategies seek to generate tax benefits through manager skill and active positioning.

Modern long/short strategies can be implemented across a range of gross exposures (e.g., 130/30, 145/45, 200/100 and beyond), allowing investors to calibrate the balance between tracking error, alpha potential, and tax-loss generation. This flexibility enables the strategy to adapt to varying risk tolerances and evolve alongside the portfolio over time.

Long/short strategies can be applied in different ways depending on the portfolio’s starting point: core builds an enhanced equity portfolio, overlay adds a market-neutral extension to existing holdings while not selling the underlying portfolio holdings, and exchange facilitates tax-aware diversification of concentrated positions.

It can be advantageous to reverse-engineer the approach and gross exposure levels by matching the role the long/short strategy plays amongst an investor’s existing portfolio assets. For example, many investors refresh their direct indexing portfolio into the core long/short approach, serving as a tool for tax-neutral diversification from highly appreciated stocks or real estate, while maintaining an allocation to equity markets.

Together, these approaches allow investors to integrate long/short capabilities without needing to restructure their entire portfolio. Rather, they can build to the selected benchmark of their choice, such as the S&P 500 or MSCI World Index.

Long/short strategies should not be viewed as a replacement for direct indexing. Rather, they can serve as a complementary tool as a portfolio evolves.

A mature direct indexing portfolio still offers valuable benefits: broad market exposure, tax-efficient ownership of individual securities, and significant embedded gains that investors may prefer to hold rather than realize.

Adding a long/short strategy alongside this exposure can introduce a new source of tax-efficient return generation without forcing investors to dismantle their existing holdings.

This layered approach allows investors to maintain the benefits of direct indexing while introducing a strategy designed to produce ongoing tax assets.

While direct indexing has been particularly effective for investors seeking to harvest tax losses during the early phases of portfolio construction, no strategy operates in a vacuum, and none remains equally effective forever. As portfolios mature, their tax characteristics change. The opportunities that existed five years ago may look very different today.

For investors whose direct indexing strategies have matured, the key question is not whether the strategy “worked.” In many cases, it worked extremely well. Instead, the question is how to continue generating tax efficiency and diversified return sources as the portfolio enters its next phase. By introducing a structure capable of generating both investment returns and tax assets, long/short strategies can help extend the tax-efficient mindset that originally made direct indexing so appealing.

This material is intended for general informational purposes only, and should not be construed as legal, tax, investment, financial, or other advice. It does not consider the specific investment objectives, tax and financial condition or needs of any specific person. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Investing involves the risk of loss, including loss of principal. One cannot invest directly into an index.

Summitry, LLC is a registered investment advisor in the State of California. For more information about Summitry, including fees and services, please see our Form ADV Part 2A or contact us directly.