Why High-Income Professionals Are Turning to Custom Indexing for Tax Control

Most investors know the go-to tools for building a diversified portfolio: mutual funds and ETFs. They’re accessible, straightforward, and offer an easy way to mirror the market. For many, these vehicles have been the default choice for decades.

But here’s the challenge: as portfolios grow in size and complexity, so do the needs of the investor. Mutual funds and ETFs, while useful, can feel limiting for those who want greater flexibility, control, and efficiency in how their money is managed.

That’s where custom indexing comes in. Often described as the “next evolution” of index investing, it allows investors to tailor a portfolio to their unique goals while unlocking distinct advantages, particularly when it comes to tax management.

In the sections ahead, we’ll explore how custom indexing works, how it stacks up against mutual funds and ETFs, and why it’s becoming a powerful strategy for investors seeking more than the traditional tools can deliver.

What Is Custom Indexing?

Custom indexing is essentially building your own version of an index, such as the S&P 500, while holding each stock individually. Unlike ETFs or mutual funds, which allow you to own shares of a fund, custom indexing means you have direct ownership of every company in your portfolio.

This ownership comes with an important distinction. With ETFs and mutual funds, the fund manager decides what is bought or sold, and investors simply come along for the ride.

Custom indexing essentially flips that model. You and your advisor determine which stocks to hold, when to harvest losses, and how to handle gains. Having this level of control and flexibility opens the door to executing more personalized, tax-efficient strategies without sacrificing exposure to the broader market.

How ETFs and Mutual Funds Are Taxed

To understand the potential tax benefits of custom indexing, let’s first take a step back and consider how the more common alternatives, namely ETFs and mutual funds, are taxed.

For the most part, ETFs are relatively tax-efficient. Investors generally owe taxes only when they sell shares of the fund for a profit (or capital gain). Depending on how long the investment is held, those gains are taxed as either short-term capital gains (at ordinary income tax rates) or long-term capital gains (which are often taxed at a lower rate than ordinary income).

Mutual funds, on the other hand, can surprise investors at tax time. When fund managers sell stocks within the fund (the underlying stocks) and realize gains, they must distribute those gains to investors, even if the investors never sold a share. That means you could end up owing tax on a gain you never realized directly. Worse still, you have no control over the timing or amount of these distributions.

The Tax Benefits of Custom Indexing

With custom indexing, you decide when to buy or sell individual holdings. Having this flexibility to control the underlying stocks removes the “surprise” factor that’s more common with mutual funds and supports a more proactive tax approach. When you’re able to determine when you sell and buy, you can more effectively align those gains (or losses) with your broader financial picture.

Custom indexing also makes strategies like tax-loss harvesting possible on a much larger and more personalized scale.

Tax-Loss Harvesting

Tax-loss harvesting is a commonly used strategy for offloading poor-performing investments in a tax-efficient manner. In simplest terms, tax-loss harvesting enables investors to “harvest” losses to offset taxable gains. 

Let’s look at an example of how this may work.

Say you sell one stock for a capital loss of $50 and another highly appreciated stock earns a $200 capital gain. Rather than paying capital gains tax on the full $200, you can offset the gain with the $50 loss, meaning you only pay capital gains tax on $150. Scaled across a portfolio of hundreds of stocks, this strategy can potentially lead to substantial tax savings.

Additionally, investors can use up to $3,000 of net losses each year to reduce ordinary income tax liability, including W-2 wages, interest, or self-employment earnings. 

With mutual funds or ETFs, you don’t have the flexibility to sell off specific underlying stocks at a loss; rather, that action is determined and executed by the fund managers. Custom indexing enables you to target opportunities throughout the year at an individual stock level.

Gifting

One of the overlooked benefits of custom indexing is the control it gives you over individual securities. That control doesn’t just matter for tax management—it also opens doors for more intentional wealth transfers and charitable giving.

Consider what happens when a few stocks in your portfolio see significant growth. You now hold highly appreciated assets with a low cost basis. If sold, they could trigger a large capital gains tax bill. With ETFs and mutual funds, you don’t have the option to separate out those positions for gifting or donation. Custom indexing changes that, allowing you to manage individual securities in ways that align with both your tax strategy and your personal values.

For example, gifting shares of appreciated stock to family members can transfer wealth without immediately realizing capital gains. Similarly, donating those shares directly to a charity or donor-advised fund can eliminate capital gains altogether while also providing a potential charitable deduction.

Is Custom Indexing Right for You?

As wealth grows, proactive tax planning and flexibility become increasingly important for high-net-worth investors. Tools like custom indexing can help you keep more of what you earn. By directly owning individual securities, you maintain greater control over gains and losses—as well as the ability to harvest tax losses year-round.

Like any strategy, it’s not one-size-fits-all. Determining whether custom indexing suits your needs will depend on your financial situation, investment goals, and tax considerations. But if you’re interested in moving beyond the limits of ETFs and mutual funds, it offers a powerful way to invest more efficiently.

If you’re interested in exploring whether custom indexing could help lower your tax liability and better align your portfolio with your long-term goals, we’d be glad to walk you through the possibilities. Give us a call today.

Robert "Fenn" Giles III, CFP®, CAIA is a Managing Partner of Wealth Advisors of Tampa Bay and serves on the firm’s Management and Investment Committees. WATB is an independent Registered Investment Advisor (RIA) located in Tampa, Florida. Learn more about them at wealthadvtb.com. 

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.