Talk to enough financial advisors about direct indexing, and the conversation often follows a familiar arc: huge tax savings in year one, followed by silence. Jerry Michael, President of Smartleaf and Smartleaf Asset Management (SAM), hears the concern repeatedly. Clients start with concentrated positions, harvest losses aggressively in that first year, and celebrate the immediate tax benefit. But after a couple of years, as positions appreciate and opportunities to harvest losses fade, some advisors start to wonder—did they oversell the story?
Michael estimates that roughly $9 billion of Smartleaf’s $90 billion in assets under management is in direct indexing, and as adoption has increased, he continues to address widespread misunderstanding surrounding the topic of direct index “lockup.”
The concern, as he puts it, goes something like this: buy IBM at $100, sell at $50 to harvest the loss, buy back after the wash-sale window, then watch it climb again. Now, you’ve got a cost basis of 50, all unrealized gains, and no losses left to harvest. “Every single security has appreciation—has unrealized gains—and look, no more loss harvesting. So, what was the point?” Michael says. “People ask us, ‘Alright, is that a valid concern? Is that a reason to think that direct indexes are overhyped, and I should just stick with an ETF?’“
His response: that question misses the bigger picture entirely.
The Operational Foundation
Many advisors assume direct indexing means added complexity—more moving parts, more time spent managing individual positions, more operational headaches. Michael pushes back on the assumption.
“They may not be for everyone, but it should never be the case that you’re not using a direct index because it’s too operationally cumbersome to use it,” he says. “That’s our main goal—to make it so that’s never the reason.”
Smartleaf’s mission centers on eliminating the operational friction that might prevent advisors from choosing the right vehicle for each client.
“Our job at Smartleaf or Smartleaf Asset Management isn’t specifically to push direct indexes,” he explains. “Our job is to make direct indexes literally as easy to use as an ETF—so there’s no operational barrier whatsoever. It’s a choice in a pull-down menu, so you can do whatever is right for your client.”
Once the friction disappears, the deeper reasons to consider direct indexing—customization, control, and tax precision—come into sharper focus.
Beyond taxes, Michael points to the flexibility that direct indexing offers: customization around values-based investing, ESG preferences, or sector exclusions for clients with concentrated employment risk, for example. Advisors can also apply factor tilts. Though the tax story is still compelling, the control alone, he says, is enough reason to use direct indexing strategies.
The Front-End Advantage
Even skeptics acknowledge that direct indexing can deliver meaningful tax savings in the first year. Michael agrees the initial loss harvesting creates real value—but argues it doesn’t stop there. Under reasonable assumptions, early tax deferral alone can potentially offset the added cost of direct indexing compared to ETFs over time. “Even if there was lockup, it’s still worthwhile simply because you’ve got all those loss harvests upfront—and that’s just the baseline,” Michael says.
Clients who hold positions until death might avoid the deferred tax entirely, converting temporary deferral into permanent tax elimination. At minimum, deferral creates measurable value through the time value of money—dollars kept invested today compound more effectively than dollars paid in taxes. The front-end benefit can justify the entire strategy, even before considering any ongoing advantages.
But the real power emerges in legacy positions.
Legacy Holdings Transform the Calculation
Often, new clients arrive with portfolios full of appreciated or concentrated positions. Managing those legacy holdings effectively can define the early success of a client relationship. Smartleaf conducted a study analyzing 18,000 real portfolios with legacy equities, comparing two scenarios: selling everything to buy ETFs versus integrating existing holdings into a directly indexed separately managed account (SMA).
The results were stark. Liquidating generated an average tax hit of 7.21% of portfolio value. Incorporating legacy holdings into a direct indexing strategy cut that cost to just 0.29%. “So, there’s an enormous win if you have legacy equities—which not everyone does, but if you do, enormous win,” Michael says.
In fact, 46% of accounts that transitioned to a direct index saw a net tax benefit, compared to less than 5% for those who liquidated to ETFs. Turnover during the transition averaged just 30.4%—versus 100% when selling to buy ETFs.
For clients entering with large, appreciated positions, that difference can translate to real, immediate alpha.
Withdrawals, Donations, and Tax Precision
The “lockup” idea assumes portfolios sit still, but they don’t. Clients withdraw cash, make charitable donations, and rebalance. Each event creates a tax consequence—and an opportunity for potential efficiency gains.
With ETFs, every withdrawal effectively sells all underlying stocks pro rata. With direct indexing, advisors can choose which holdings to sell—typically those with the smallest gains. “Even in a locked-up direct index, you’ve got 500 stocks or whatever number you have—maybe it’s less than 500, but 150—you don’t have to sell them pro rata,” Michael explains. “Some of those have lower gains than others, and you can selectively sell whatever holdings have the least gains. So, every time—literally every time—you make a withdrawal of cash, it will be more tax-efficient with a direct index than with an ETF, even if there is so-called lockup.”
The same logic benefits charitably inclined clients. ETF donations are forced pro rata, but with a direct index, advisors can handpick the most appreciated stocks to donate, aiming to enhance the deduction.
“You can do the reverse of the cash withdrawal—you can find the very most appreciated stock and donate that, and get the maximum tax advantage you get from the step-up in basis when you donate to charity,” notes Michael.
The Rebalancing Edge
One of the clearest advantages of direct indexing emerges during rebalancing. Imagine a portfolio overweighted in large-cap securities and underweighted in midcaps. Rebalancing with ETFs means selling part of the large-cap fund and buying the midcap fund—triggering taxes on all stocks in the fund, including those nearly identical to what you’re buying.
“You accomplish nothing at all by selling the smallest large-cap just to buy the biggest midcaps. Nothing—you just wasted taxes to accomplish nothing,” Michael emphasizes.
With direct indexing, advisors can skip those redundant trades. “If this is a direct index, you don’t have to do this,” he adds. “You wouldn’t sell the smallest large cap just to buy the biggest midcap, because that accomplishes nothing. And you don’t have to sell all 500, or whatever it is, pro rata—you can selectively choose to sell the things that are least appreciated.”
The selective approach might concentrate sales in one sector, but the advisor can buy the same sector in midcap stocks. “So, you’ve got your capitalization right, you’ve got your sector right, your industry right, P/E right—all of that can be done, and you’ve done it for a fraction of the tax costs,” explains Michael.
The rebalancing advantage extends beyond simple drift management. Tactical asset allocation changes, factor tilts, or model updates all benefit from the same surgical precision. “You have that surgical ability with the direct index to be much more selective in what you sell,” Michael notes.
Better Tax Management = Better Risk Management
Another potential side effect to all this tax efficiency? Better discipline.
Michael notes that because ETF-based rebalancing tends to be clunky and tax-heavy, many advisors delay it—letting a 70/30 portfolio drift to 75/25 or even 80/20 before triggering a rebalancing event. The tax drag discourages discipline.
“With a direct index, if it’s supposed to be 70/30, you can do something when it’s 71/29,” Michael says. Selling a handful of stocks at small gains or losses can keep portfolios aligned without triggering massive taxable events. “So, you win not only on taxes—you win on asset-class drift as well.”
Superior risk management can emerge as a byproduct of superior tax management. The ability to rebalance more frequently, with minimal tax impact, allows advisors to maintain tighter risk controls and keep portfolios aligned with client objectives. Asset-class drift, sector exposures, and factor tilts remain within tolerance bands rather than being carried to uncomfortable extremes before action becomes financially justifiable.
The Real Question About Tax Management
The “lockup” debate, Michael argues, stems from a narrow definition of tax management. Advisors fixated on loss harvesting miss the broader palette of tax-optimization techniques available throughout the client relationship. “What’s going on here is that they’re simply equating tax management with ongoing tax-loss harvesting—and that’s not all of tax management,” he says.
Thorough tax management spans the entire client life cycle: onboarding legacy assets, managing withdrawals, handling charitable donations, and rebalancing. Each moment presents chances to either waste or preserve tax value.
According to a recent Smartleaf simulation that modeled daily returns over one year across different market conditions, direct indexes can achieve three to five times more loss harvesting than ETFs—five times in up markets, three in down. By selling individual stocks instead of entire baskets, advisors can defer more gains and harvest more losses over time.
Making Sophistication Simple
The technical sophistication and potential risk management benefits of direct indexing matter only if the strategy is easy to execute. That’s where Smartleaf comes in.
“Everything we do is boring—and everything we do, any good advisor already knows how to do,” says Michael. “They just don’t have the time to do it every day, for every portfolio. We do. We’ve automated it.”
Smartleaf’s software and sub-advisory service handle the daily grind: tracking tax lots, generating trades, and producing client reports. “Being able to do the basic, boring bits of tax management, expense management, and risk management every day, and do it expertly for every portfolio—it makes a huge difference,” he says.
The firm also produces an Estimated Taxes Saved or Deferred Report for each account, breaking down savings into three components: taxes deferred from gains not realized, taxes saved from short-to-long term gains conversion, and taxes saved from net loss harvesting. In 2023, clients of SAM users saved or deferred an average of 1.68% of actively tax-managed assets. As Michael points out, for the majority of clients, the saved or deferred taxes exceed advisor fees.
Advisors can also model scenarios in real time, showing clients the tax impact of screens, exclusions, or transition plans instantly. They can compare broad versus narrow screen definitions, and generate a five-year transition plan on the spot. “You don’t have to wait two weeks to get a PDF from some financial engineering team,” Michael says. “All of this can be done on the fly, live by the advisor in front of the client if they wish. And all that is the power the advisor gets because there’s an automated system that can show them the tax and risk implications of any decision they make.”
The platform supports flexible open architecture, accommodating any combination of ETFs, mutual funds, direct indexes, and active equity strategies. Advisors specify preferred asset allocations and product choices, leveraging a robust third-party model hub or using proprietary models. Customization extends to individual accounts without limitation: unique asset allocations, specific product selections, ESG or religious constraints, sector restrictions, and exclusions down to individual securities.
The Adoption Pattern
Among Smartleaf’s wealth management partners, Michael notes that a clear pattern has emerged: advisors keep existing ETF positions with low cost bases, but new money is flowing differently. “If you have an ETF with a low basis, there’s no point in selling it and buying a direct index,” he acknowledges. “But all new assets, effectively across all clients, go into direct indexes. That’s a trend we see.”
Once operational barriers disappear, the value proposition is difficult to ignore. “Direct indexes don’t have to be complicated at all,” Michael stresses. “All Smartleaf Asset Management does is the same thing our software does—make personalization, tax management, and risk management possible to do expertly. The basic stuff, for every account, every day.”
Smartleaf’s system—built more than 20 years ago—now manages upwards of $75 billion in assets, automating tax-sensitive transitions, ongoing harvesting, gains deferral, and optimal lot selection.
The “lockup” myth assumes that tax alpha fades after year one. Michael’s argument shows the opposite: direct indexing can deliver tax efficiency across every phase of a client relationship, and each stage presents opportunities for optimization.
“They’re good for clients,” Michael believes. “If you have fractional shares, we have people with direct indexes down to $5 in assets. It is possible. All of that’s possible. So really, it’s about what’s right for the client.”
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