Hopefully you stayed awake during last week’s article on Direct Indexing. I promised I would share some thoughts on when I think it makes sense to do Direct Indexing and also times to avoid. It is not a cure-all, however, it definitely is a popular theme in my world right now. I was at the gym this morning on a stair climber (brutal machine) and one of the TVs was playing a commercial from Schwab about their version of Direct Indexing for retail clients. Again, popular product now so I figure the timing is right to dump a bit more information.
First off, one of the biggest benefits of Direct Indexing (DI) is related to taxes. Tax efficiency to be exact. You know, tax loss harvesting, focusing on certain tax lots, dealing with concentrated stock and more. Because of that, DI does not really make sense for any tax-deferred or tax-free investments. You know, your IRA or a Roth IRA. IRA distributions are taxed as ordinary income so reducing taxes before then really has no impact. And Roths are never to be taxed again. So, I take IRAs and Roths off the table when it comes to DI.
Now, you may be wondering about the screens I mentioned last time. Again, DI allows you to get more focused with your investments and you can add screens to do things such as exclude big oil or gun companies. This may make sense for your IRAs and/or Roths, but this is an investment screen and not Direct Indexing in the purest sense how I use DI. My point is if you want to go the Socially Responsible route with your IRAs and Roths you can, just look more for screens than for tax-efficient products. But screens are a whole other topic we aren’t here to discuss.
Let me clarify one point I mentioned in the previous paragraph. Direct Indexing in its purest sense is tax-focused investing. There are all kinds of subsets of DI where you can add these screens or build out your own portfolio with specific stocks based on whatever it is your heart desires. The DI I use is focused on taxes because this is one of the places where I bring the most value to my clients and it is one of the places that improves long-term performance the most. I’m sure I will talk about the other types down the road, but today we are talking about pros and cons of tax-focused Direct Indexing.
There are two big cons we need to discuss. These are things I consider when talking to a client about DI and I guess it is up to you if you want to consider them for your personal situation. Again, it all comes down to taxes.
The first con is related to all the tax-loss harvesting done in DI portfolios. The concept here is when a stock goes down a predetermined amount you sell it. Then you either buy a highly correlated but different stock, such as selling Home Depot and buying Lowes. Or you wait until the wash-sale period has expired and rebuy the stock you just sold. What happens over the long-term with a lot of tax-loss harvesting is you may end up holding a bunch of highly appreciated stock. That is an issue because the tax man will eventually show up and your portfolio may only be up. Good problem to have, right?
When you sell these appreciated stocks you are paying taxes at the Capital Gains rates, which hopefully will be lower than your Ordinary Income rate. Here is the second con. DI as I consider it makes sense if your income will be dramatically lower down the road. Simple example here. Let’s say you make $400,000 a year and are 50 years old. You are planning to “retire” at 62 and start Social Security at 70. Well, you have a nice period of time here where your taxable income will be lower and also your Capital Gains rate. So, in this situation selling highly appreciated stock within a low-tax environment would work. However, if you were planning to work until 72 and continue to make $400,000 a year to the point when RMDs kick in, well, it may not make as much sense. Again, it is critical to look at the forest and the trees.
Side note. An easy way to deal with highly appreciated stock is to either donate it to a charity or leave it for your kids to inherit when you pass. They get a nice step-up in basis for inherited stock.
The biggest pro I want to talk about comes down to where I bring the most value to my clients. Behaviors. Studies have shown that investors using Direct Indexing do better over the long-term. You may be thinking it is because of the tax focus. That is sort of it, but the real reason is because they are more consistent in following a DI strategy than chasing the new hot fad. This is amplified when screens are incorporated. When you have a DI strategy that is fully in-line with your values and what is important to you, you aren’t really going to deviate from that strategy by making constant changes.
The other pro is one I have hammered on repeatedly. The tax advantages. I won’t repeat it, except below.
To me, Direct Indexing addresses the two biggest areas where an advisor can bring value to clients. First is with taxes. As I mentioned in another article, DI can add up to 1.5% of value to a client. And focusing on Behaviors can add another 2%. I don’t know about you, but an additional 3.5% of value is a good thing in my book.
Ultimately, Direct Indexing is a good thing in my mind. It is NOT a silver bullet in the world of investing like some of the advertising is pushing. However, when used in the right scenarios it can be highly beneficial. Just be sure to ask your advisor for the pros and cons for your personal situation. Otherwise this may just be another investment fad you are chasing as opposed to an investment strategy that is truly personalized for you.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.