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Revisiting Direct Indexing Thumbnail

Revisiting Direct Indexing

I wanted to take a couple of minutes this week to revisit a topic I have discussed before – Direct Indexing. I’m staying high-level here and it should take no more than two minutes to read.


What is Direct Indexing?

  • Short version is instead of holding an investment such as an ETF (Exchange Traded Fund) that represents an index (S&P500), you hold individual stocks that as a group have a high correlation to that same index.
  • Direct Indexing can take lots of forms, such as creating an index that includes or excludes certain themes you may or may not wish to invest in. One example is to support pro-environment companies. Another theme can be religious based (Sharia Law indexes are really cool to me).
  • Personally, I focus on Direct Indexing for tax management as my clients are high-income earning physicians who would rather not tip Uncle Sam.
  • So, everything I am explaining here is through my tax-focused lens.


Quick History:

  • Direct Indexing has been around for years. However, they used to have a very high entry point due to how expensive it was to run the portfolios.
  • As technology has improved within the world of investing the point of entry is much lower.
  • However, not all direct index providers are built the same and have strong track records (I will touch on this more in a minute).


How It Works:

  • I’m keeping a super simple example here.
  • Say you want to buy a Direct Index model that represents the S&P500. Your model probably has around 100-150 individual positions, and this may give you something like a 99% correlation to the S&P500.
  • Let’s say one of your holdings is Lowes Home Improvement stores. Say they have a bad run and the stock drops 15%. You end up selling Lowes, grab the tax loss to reduce current or future tax bills (tax loss harvesting), and use the proceeds to buy Home Depot, another home improvement company.
  • Again, you grab the tax loss and stay highly correlated to the Index.


Who This Makes Sense For/Benefits:

  • If you are saving money into Taxable accounts you may want to consider Direct Indexing.
  • Also, if you are in a higher tax bracket it should be on your radar.
  • This can make sense for those concerned about high investment fees. Sometimes Direct Index investing can be cheaper than investing in ETFs and almost always cheaper than traditional Mutual Funds. The reason is because the ongoing fees are related to running the Direct Index portfolios. Buying and holding the stocks cost nothing, unlike ETFs and Mutual Funds that have ongoing fees.


Things to Think About:

  • If you are not investing in a Taxable account, they may not make sense (at least as I am discussing Tax-focused Direct Indexing).
  • Check the track record of the Direct Indexing company. The provider I use to run the Direct Index portfolios I design has been doing this for decades. Not everyone has, including Vanguard.
  • An example of the above is I know an advisor using a brand new Direct Indexing company. Their S&P500 portfolio is all 500 members of the index. Ughhh.
  • Be careful of the fees. Not all providers charge the same. I know my portfolios can come in around .25%, which is as cheap as some all-ETF portfolios.
  • Know your statements will get larger as you will be holding 100+ different stocks. And don’t worry about your CPA as the tax statements are provided electronically.
  • Eventually all of your holdings will be positive as you sell off the losers over the years. This seems like a good problem to me😉


Final Thoughts:

  • Direct Indexing works best in years when the market moves around, which is pretty much every year.
  • Last year the S&P500 was up over 24%. I have a client and their Direct Indexing portfolio added nearly another 2% to their performance through tax management.
  • Here is a quick example of why Direct Indexing can be so powerful:
    1. In 2020 the S&P500 was up over 16%.
    2. Roughly 60% of the holdings were up, which means 40% were down.
    3. Had you held the individual stocks you could have sold those that were down, kept those up and most likely had performance better than 16%.