How Direct Indexing Can Provide Relief in Volatile Markets

Key takeaways:

• Periods of market volatility test our nerves but can also present opportunities
• Volatile markets are a good time to harvest tax losses for use later to offset taxable gains
• Using a direct indexing strategy can allow investors to selectively harvest losses that can then be used to offset gains from other parts of their portfolios

Investing in stocks so far in 2025 has not been for the faint of heart. Some market indices have undergone wild swings, flirting with bear-market territory. And with a lot of unknowns still to be resolved, we expect markets to remain choppy for a while.

These periods of volatility may be nerve-wracking, but they can also present opportunities. Here’s how your clients can take advantage of the volatility by employing tax-loss harvesting strategies in a Direct Indexing portfolio to potentially reduce tax liabilities.

The central goal of direct indexing is to build a portfolio that imitates an index while maintaining the flexibility of holding each security separately. With direct indexing, the investor owns the actual basket of stocks that are representative of the chosen index. For example, a direct indexing portfolio in a separately managed account (SMA) tied to the S&P 500 Index could hold anywhere between 200 and 400 stocks.

The advantage that direct indexing holds in volatile markets is that since the investor owns the individual securities, the portfolio manager can select which declining stocks to sell, and the subsequent losses then belong to the investor. The investor can use those losses at a later date to offset gains in other parts of their portfolio. That can be extremely helpful in reducing the investor’s tax bill and is why we often refer to tax losses as tax “assets.”

These tax “assets” offer increased flexibility to help your clients manage their tax bill. As noted,  any losses harvested belong to the investor and can be applied indefinitely against any future gains (up to $3,000 of residual losses can be utilized to offset income annually). In fact, these losses can be used to offset gains not only in an investment portfolio but also those resulting from the sale of other assets such as an investment property or business.

The last major period of volatility was in 2022, when the S&P 500 lost 18%. A direct indexing strategy would have had the ability to capture significant tax losses—thanks to the market volatility and the strategy’s ability to tax-loss harvest. This highlights a key advantage for long-term investors: the ability to “bank” losses during volatile periods and use them immediately or in the future to offset gains.

Direct Indexing within the Russell Investments’ Personalized Managed Accounts (PMA) program may offer even more advantages. The personalized SMAs can be managed for tax efficiency, and tax-loss harvesting would be an essential part of their broad tax-management toolkit. With PMA the investor can use losses in one SMA to offset gains in other holdings in their overall household level account.

The ability to tax loss harvest doesn't make up for the market losses clients occasionally experience but it can soften the blow. Make sure your clients know there's a cushion out there.