Today we are going to talk about another tax-smart investing concept here. The focus is really on investing as we are going to cover Indexing. Specifically, Direct Indexing.
The short definition is Direct Indexing is building out an investment portfolio to track the performance of a specific index. However, you do it through buying individual positions instead of buying an ETF (Exchange Traded Fund) or a mutual fund.
The concept of direct indexing has been around for years as it provides many benefits, which we will cover today. However, it hasn’t really been available to the masses as it was expensive to administer and the investment companies that provided direct indexing had to set high minimums due to their higher costs. Fortunately, technology has advanced enough to provide more access to the continuously increasing interest in direct indexing. How about we cover a little bit more of the concept.
I’m going to use an overly simplified example here to explain the concept of direct indexing. In this case, I am going to use the popular S&P500 Index. Everyone knows this name. It is the 500 largest publicly traded companies in the US. You can easily buy a mutual fund through places like Vanguard or ETFs via iShares and other investment companies. All these investment companies have low-cost products doing their best to replicate the S&P500.
I say do their best as none replicate the S&P500 identically as it is constantly changing. Direct indexing is not attempting to better replicate indexes. Instead, their advantage comes to being more tax smarter (please note my tongue in cheek term here, but the goal is to be a tax-smart investor with direct indexing).
Back on topic with my example. An investment company decides it is going to offer a direct indexing product to match up with the S&P500. Now, they do not have to buy 500 different positions. Instead, they do their analysis and realize they can build a direct indexing offering with high correlation to the actual S&P500 index but with maybe 80 holdings. And this is key. Each holding is separate and is not bunched together into an ETF or mutual fund type of product. This is where you start to see the separation of how direct indexing can be more tax efficient than a mutual fund or even an ETF.
MUTUAL FUNDS AND ETFS
Let’s dive a bit deeper into that just to explain how mutual funds and ETFs work in the world of tax smart investing. I am going to pick on mutual funds first.
Mutual funds have been around for what seems like forever. When created they were cutting edge. The goal was typically to create a mutual fund that was comparing itself against a benchmark, like Large Cap Growth. The managers of the funds would pick and choose individual companies they thought would outperform their benchmark.
There are a couple of key issues with mutual funds that made outperformance tough. First, is they are expensive. Well, they are less expensive now, but most are still more expensive than ETFs. Next, they also have the capability of creating a big tax headache via a tax bill. They simply are not super tax efficient. Finally, when selling mutual funds they do not get priced until the end of the day. So, if you see the market is down one morning and want to sell that fund to take advantage of the drop, you had better hope it does not go up in value during the day as it does not settle in price until the end of trading. The short version is they are not as agile as ETFs or individual stocks.
Now, ETFs were created to sort of take out the middleman. Exchange Traded Funds (ETFs) typically say instead of having an expensive manager who is trying to outperform an index, let’s just try and match the performance of the index. This helps keep costs lower as there is less trading and not as much overhead. Plus, they are much more tax efficient. Finally, they trade like a stock. So, in the example before if you saw your ETF was down in value and you wanted to sell it to maybe do some tax-loss harvesting, well, you can do that with an ETF because they settle once the trade is executed and do not have to wait to end of the day like a mutual fund.
A bonus with ETFs is you can do some nice tax-loss harvesting work. I know I have posts on my blog about this, but let me explain it quickly. Let’s say you bought the iShares S&P500 ETF and unfortunately, since the time you bought it the investment has dropped in value. It is now down 10%. Something available to you is to sell the iShares S&P500 ETF, grab the losses, and take the sale proceeds to invest in something like the Vanguard S&P500 index immediately. Under the current rules, this is not in violation of any wash sale rules, which basically says you cannot sell a holding at a loss and buy it back within a month while still maintaining that loss to lower your taxes. ETFs can do this tax loss harvesting because no two are the same. So, even though the iShares ETF and the Vanguard ETF are both investing in the S&P500, they are not identical.
TAX EFFICIENCY WITH DIRECT INDEXING
That is enough background. I now want to illustrate how direct indexing can now get even more tax efficient and tax smart than ETFs.
Again, simple example is that AAA investment company created a direct index of the S&P500. Their direct index product only holds 80 individual stocks though instead of 500. However, these 80 stocks create a model that has high correlation to the full S&P500 index. This means they move in pretty much the same direction as the market moves.
As you pull back the layers of the S&P500, you will find those 500 companies do not all move in the same direction. Let’s say you bought an iShares S&P500 ETF. Some companies in that ETF may be up since you bought it and others may be down. However, the total value of the ETF is up. But, wouldn’t it be great if you could somehow get super surgical with that ETF and sell those individual positions with losses to help lower your tax bills? This is where direct indexing comes into play.
Going back to the AAA investment company direct index of the S&P500, you can now get down to each individual holding to do some tax loss harvesting. Again, you sell those positions with losses for tax purposes and then use the proceeds to buy a similar, but not identical, holding.
The example is your AAA index happens to have Lowes Home Improvement as one of its 80 core holdings and it is the only holding within the whole index that is down in value as the overall value of the entire index is up. In the direct index, you can go in and sell the Lowes position, grab that loss and then go buy something like Home Depot so you still have an overall index with high correlation to the S&P500.
Again, super simplified example of what exactly is direct indexing. This is a new investment technique that provides much more flexibility. And this flexibility extends beyond just being tax smart. You can create direct indexes that maybe fit your political or social points of views. You know, maybe you don’t want to buy an S&P500 ETF because there are gas companies in there, or alcohol, or tobacco, or guns, or whatever. With direct indexing you can create an index similar to the S&P500 index, but cuts out those specific companies you don’t want to support through investing.
I firmly believe direct indexing is the next stage in investments. I guess we have gone from individual stocks to mutual funds to ETFS and are now sort of back to individual stocks, but with an index twist to them. Regardless, technology has now advanced enough to make the entry price point to a more reasonable one for the average investor. And in my practice, they help clients be tax smart as they know it’s not what you make, it’s what you keep.
FLASHBACK - MOTORCYCLE OWNERSHIP
Welcome to the flashback section. I mentioned in a previous episode how I decided not to buy a Jeep because it felt too dangerous. And instead, I made the decision to buy a motorcycle. Which is of course much less dangerous.
I won’t bore you with all my motorcycles story. It is another item I always wanted to own. Well, the stars were aligned in college for me to check this item off the old bucket list.
As I mentioned, I worked at a store called the Wicker Company. It was a patio furniture store during good weather and Christmas stuff from September through December. Anyways, we had this sale one summer and everyone was eligible for bonuses based on total sales and how much you worked. Well, I was a warehouse/delivery guy and I ended up working the second most hours of anyone there. Part of the reason we sold so much furniture was because we would deliver it immediately. This meant lots of hours delivering. Plus, most of my coworkers in the warehouse did not think we would hit the sales goals, which meant a big bonus. I did so I racked up the hours banking on a big bonus.
So, the big bonus arrived in my pay and I had money to burn. Tuition was paid through a scholarship and my regular pay covered my apartment and living expenses. A friend of mine had a motorcycle and had been riding since he was five years old starting within mini-bikes. I told him I wanted a sportbike and he helped me find a good used one.
I bought a Katana 600 in the early fall when they were cheaper. Now, I couldn’t even ride so my friend had to test it out for me. During the winter I kept the bike at his place as his college apartment actually had a garage. Once the weather broke in the spring I was riding it all the time though.
No exciting stories with it as I was super cautious, at least for a 21-year old. I only ever gave one person a ride. It made me so nervous I never put anyone else on it. I also always wore a helmet and long pants. The most dangerous thing I ever did was getting caught in a downpour one evening going home from work. That was not fun.
Ultimately, I sold the bike about a year and a half after I bought it. I sold it in the spring to try and get top dollar. Actually, I sold it for $100 less than I paid for it a couple of years before. Sadly, I had to sell it as I was going off to grad school and knew I would never have time to ride it. I took the proceeds and bought a computer. Yuck!
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
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.