We have written and podcasted on direct indexing in the past. The concept isn’t particularly new – there have been separately managed accounts (SMAs) available for years that have employed similar strategies around index replication. With the advent of fractional shares available at some custodians, improved software for tax efficient implementation, and competition driving prices lower, the perfect storm for direct indexing appears to be now.
What is Direct Indexing?
Direct Indexing simply is a basket of stocks that is meant to replicate an index, a theme, a sector, or a combination of any of these. For example, one could equally weight all 500 stocks in the S&P 500 to replicate the makeup of the S&P 500 Equal Weight Index (an example can be found here). With some rebalancing software, it may be relatively easy for an investor to do it themselves. More difficult would be to replicate the S&P 500 itself, as it is market capitalization weighted. These weightings change over time, so the portfolio weights for each security would also have to be shifted. This would prove to be a more difficult task, one that likely will require a manager to assist in the construction of this as well as the implementation.
Tracking Error
Tracking error refers to the difference between the weightings of the benchmark – in my earlier example, the S&P 500, and the actual weightings. There could be good reasons why one would not trade to completely replicate the benchmark, including recognizing potential capital gains. Tracking error could cut both ways – if the winners were allowed to run and continued to take off, you may outperform the benchmark. Conversely, an intentional overweight to a stock or sector could also cause underperformance. In itself tracking error is not a good or a bad thing unless you are trying to be very true to your index, and in this instance it may be a goal to minimize it.
Tax Management
One of the most significant benefits to direct indexing is the ability to directly control when gains and losses are recognized. If you had 500 stocks in your portfolio not every stock will be up at the same time, and when allocations have to be adjusted for any reason due to imbalances in the portfolio or due to rising cash, losses can be recognized to help offset gains. Certain stocks can also be substituted for each other as well, maintaining the target asset allocation but allowing for a stock to have losses recognized for end of the year tax planning. For example, if you had a loss in Ford stock you may take the loss in December, buy GM stock until the end of January, and buy back Ford stock if desired.
The ability also to carry forward losses to future years may also help offset future capital gains, whether they be in a stock portfolio or in another asset class, such as private equity, real estate, or a sale of a business entity.
Bespoke Portfolios
Not only can a portfolio be used to replicate a standard index, it also can be designed specifically for an investor and/or investment advisor to tilt the asset allocation to better match their needs. For example, if you work at a social media company with a significant amount of employer stock you may choose to have very limited exposure to social media stocks in your portfolio. You may also tilt your portfolio to dividend paying stocks, small caps, or international securities should you have a high conviction in an investment theme. Some investors also want to support companies with higher environmental, social, and governance (ESG) scores, and this can be achieved through many direct index providers.
Listen Now: Past, Present, & Future of Investing In Taxable Accounts
Clint & Keith discuss investing in taxable accounts. We explore the history of investing, which started with the purchase of individual stocks by investors and then the development of mutual funds, which collectively helped pool risk and provide greater diversification.
Higher Net Fees….Better After-Tax Result?
With a significant allocation of funds to index funds beginning in the early 2000s and continuing to this day, costs have dropped significantly for both mutual funds and ETFs. ETFs also commonly are very tax efficient, historically spinning off very few capital gains with their structure. Most ETFs that seek to replicate index funds can be had for less than 0.15% annually, and in many cases under 0.10% for the most widely followed indexes. Here is some information on low cost index funds.
Direct indexing from our research is usually found in the 0.25% – 0.40% level depending on asset size (which, in our opinion, should probably be in the $500k range or more to implement this strategy efficiently). Here is a link to Schwab’s offering as well as one of Fidelity’s managed offerings. So why do we list “lower net fees” as an advantage? Potential tax savings on an after tax basis. If you have a wide enough breadth of stocks, it is not inconceivable that there will be many years where you will show a capital loss on your taxes.
An example: If you had one direct index investment solution that seeks to replicate the S&P 500, you would essentially own 500 separate stocks. If you have a gain in both investments and had to free up cash, you could sell some winners and losers in your direct index portfolio, free up cash, and keep your allocation essentially the same. You are very likely to do this at a minimal gain or potentially even at a tax beneficial loss. In contrast, you could own one S&P 500 ETF (that was extremely inexpensive!) to get the same exposure. To free up cash, if the fund has increased in value, you may have no choice but to recognize capital gains with no offsetting loss.
As a wealth manager, part of our fiduciary responsibility is to select investments that potentially could provide for better after-tax returns. While expenses are important, sometimes recognizing higher fees could be in the client’s best interest.
Also consider this: direct indexing could be used to keep non-dividend paying stocks inside of a taxable account in order to minimize dividend income while income producing securities such as dividend oriented stocks, preferred stocks, and bonds are held in tax advantaged accounts such as IRAs. These are all things that won’t show up on a performance summary but may have a significant impact on your after-tax returns.
Drawbacks
As mentioned above, these products can carry fees that may exceed that of commonly held index funds. In many cases, these fees could be lower than standard actively managed funds as well as many ETFs. It also may be harder for the “do it yourself” investor to implement, as many of the solutions are offered by financial advisors only. These strategies are also mostly designed for individual equity holders. Presently, there isn’t much of a solution that does the same strategy with individual bonds.
While these are drawbacks that should be considered, one should be prepared for the annoyance of large statements and confirmations. If you choose a very broad based strategy, you may end up with hundreds, or possibly thousands, of individual stocks. This can certainly fill up your physical or virtual inbox, so be ready to get your email filters set up!
Is Direct Indexing Right For You?
In our opinion direct indexing is best suited for people that have significant assets in taxable accounts and a desire to customize certain aspects of their portfolio. Contact us today if you have a desire to look deeper at your portfolio and see if it can help you.
ABOUT THE AUTHOR
CLINT WALKNER
FINANCIAL ADVISOR
Clint Walkner is one of the co-founders and managing partners of Walkner Condon Financial Advisors. He is a fee-only, fiduciary financial advisor who works with clients locally in Madison and around the country.
You should always consult a financial, tax, or legal professional familiar about your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost.