As consumers, we’ve come to expect customization and personalization with most things these days, whether it’s our coffee order, streaming preferences, or insurance policies…So why should our investments be any different?
With direct indexing, investors can create custom portfolios based on their specific goals, values, and preferences.
Listen now and learn:
- How direct indexing differs from ETFs and mutual funds
- The benefits of direct indexing
- Types of investors best suited for direct indexing
Listen Now
Show Notes
As consumers, we’ve come to expect customization and personalization with most things these days, whether it’s our coffee order, streaming preferences, or insurance policies…So why should our investments be any different?
With direct indexing, investors can create custom portfolios based on their specific goals, values, and preferences, rather than relying on pre-packaged ETFs or mutual funds.
In this episode, we’ll be exploring how direct indexing differs from ETFs and mutual funds, ways direct indexing can help boost after-tax returns, and the ideal types of investors who could benefit from direct indexing.
Let’s dive in…
Direct indexing goes by a few names these days: direct indexing, personalized indexing, custom indexing…But they all make use of something called a Separately Managed Account or SMA.
SMAs have been around for several decades but have become increasingly popular in recent years as advances in technology have made it easier and more cost-effective to manage customized portfolios as well as a shift in investor preferences towards more individualized investment solutions.
Direct indexing is a term used to describe the use of an SMA to build a portfolio of individual stocks that mimic the composition of an index, such as the S&P 500 or Russell 3000.
Understanding How Direct Indexing Works
To understand how direct indexing works, it’s helpful to start with how it differs from traditional investment vehicles such as ETFs and mutual funds.
Imagine you and me each own shares of an S&P 500 Index mutual fund. The mutual fund combines our funds into a single pool of assets that owns the underlying securities of the S&P 500 with the explicit goal of tracking that index. All costs of the fund are shared between all investors.
Costs include commissions, bid-ask spreads, market impact, opportunity cost of holding cash, cost of borrowing with lines of credit, and taxes.
Taxes are particularly important in this conversation because mutual fund managers tend to deal with investors “in cash,” meaning they must sell securities to raise cash for investor redemptions.
Each day the mutual fund manager will buy and sell securities in response to investors’ cash flows and the rebalancing needs of the fund. Whatever taxable gains and losses are accumulated throughout the year are distributed to shareholders at the end of the year via a capital gain distribution.
Let’s say I need to sell all my shares of our S&P 500 Index fund, but you continue to hold the fund throughout the year. Because mutual funds tend to deal with investors “in cash,” they must sell securities to raise cash for my redemption. But you are stuck with the capital gains incurred as a result of selling securities to generate cash for redemption.
This is the big downside of a mutual fund….If I sell my shares of our S&P 500 Index fund, I get my cash out while you and the other holders are stuck with the capital gains realized when I redeemed my shares.
Exchanged traded funds, or ETFs, are a bit different because they have what’s called an “authorized participant” acting as a middleman in the transaction.
So imagine you own an ETF tracking the Russell 3000 Index. I decide I’d like to buy shares of that same ETF, so my cash is sent to a brokerage firm acting as the authorized participant who then delivers a basket of securities to the ETF. When I go to sell my shares, the ETF sends the brokerage firm acting as the authorized participant a basket of securities and the brokerage firm then delivers me cash.
Because the fund is delivering a basket of securities at redemption rather than liquidating the securities for cash, my exit from the ETF doesn’t leave remaining long-term shareholders with a tax bill.
That ETFs minimize the effect of investors’ activity on long-term investors is one of the primary benefits of the ETF structure.
But what about Separately Managed Accounts (or SMAs)?
Unlike a mutual fund or ETF, an SMA allows an investor to directly own individual stocks that track a specific benchmark such as the S&P 500 or Russell 3000. Because you have direct ownership of the individual securities, it allows for some unique benefits that aren’t may not be possible with an ETF or mutual fund wrapper.
Benefits of Direct Indexing
Direct indexing offers two primary benefits that are not available with ETFs and mutual funds.
The first is the ability to customize the portfolio based on your objectives and preferences.
For example, if an investor is concerned about environmental, social, and governance (ESG) issues, they can create a portfolio that reflects their values by excluding companies that do not meet their ESG criteria or, overweighting companies that do meet their ESG criteria, or some combination of both.
Similarly, there are lots of factor funds available off the shelf, but direct indexing allows you to create customized factor tilts to certain characteristics like value, momentum, or profitability.
Another useful form of customization comes into play for people who receive equity compensation from their employer. In these instances, it’s easy to exclude that company (or even the entire sector) from your portfolio so that you don’t further concentrate your financial well-being to a single company or market segment.
Beyond customization, the other significant advantage of direct indexing is the potential to boost after-tax returns.
Direct indexing enables investors to take advantage of tax-loss harvesting opportunities by selling losing positions and buying similar stocks to maintain their exposure to the market. For example, maybe your SMA manager sells Coca-Cola at a loss and buys Pepsi…or sells Johnson & Johnson at a loss and buys Pfizer in its place…or sells Exxon Mobile and buys Chevron…you get the point.
Unlike an ETF or mutual fund, which requires the entire index to be at a loss in order to perform tax loss harvesting, investors can harvest losses at the individual security level within an SMA, which can boost after-tax returns.
Now, you might be wondering: are there really that many losses available for harvesting given that the stock market is up most years?
In a recent piece from Vanguard, they showed that the S&P 500 was up 9.76% in the fourth quarter of 2021, yet there were still 133 individual companies that lost value during that time. According to that same Vanguard piece, they found that daily tax loss harvesting boosted some investors’ after-tax returns by 1-2% or more.
Sound too good to be true?
Like anything good, there is a downside. For a fund that is constantly selling the losers at a loss and holding winners with gains, eventually, you will have what looks like a very low-basis index fund with a higher expense ratio than you’d pay for an ETF or mutual fund tracking the same index.
It’s a valid concern, but it’s not terribly difficult for the compounding tax benefit to offset the cost. Especially now that the cost of SMAs has fallen so dramatically.
Ideal Types of Investors for Direct Indexing
For a long time, SMAs were only cost-effective for ultra-high-net-worth investors. Just being able to afford to buy the stocks needed to approximate a given index’s performance was a barrier to entry, but regularly rebalancing a portfolio of hundreds if not thousands of stocks so that the portfolio continued to track the desired index was also difficult, time-consuming, and costly.
But several developments have helped make these strategies more economical for a larger group of investors. The biggest change is that software innovations have automated processes such as regular scanning for tax loss harvesting opportunities and rebalancing. The reduction in operating costs due to technology has not only reduced the cost of SMAs, but reduced the minimum investments required to use such accounts.
Other important developments include brokerage firms offering commission-free trading – dramatically reducing transaction costs – and the ability to buy fractional shares – making it more affordable to fund an SMA tracking a given index.
That said, not every investor will benefit from direct indexing. Typically, direct indexing is best suited for:
- Investors in a higher federal income tax bracket and/or lots of capital gains to offset could benefit from the tax loss harvesting capabilities of direct indexing.
- Investors with strong ESG convictions or preferences that require more precision than could be achieved through a pre-packaged ETF or mutual fund.
- Investors seeking specific factor exposure, such as value or profitability, built using existing holdings.
- Investors with concentrated positions can use direct indexing to build completion portfolios around large existing stock holdings. This allows investors to diversify their portfolios while maintaining exposure to specific stocks or sectors they may want to hold (for personal or financial reasons).
Investors that receive equity compensation or whose livelihood is closely tied to the health of one segment of the economy may benefit from excluding that exposure from their portfolios.
The same goes for business owners. Not only is their financial well-being likely tied to a specific area of the market, but using direct indexing to bank tax losses for use at the time of their eventual exit from the business is a common use case for direct indexing.
Conclusion
Direct indexing can be a powerful investment strategy that offers a level of customization and tax efficiency that may not be possible with a traditional mutual fund or ETF.
Want to learn more about how we use direct indexing at Plancorp? Schedule a call with me to learn more.
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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