What is Direct Indexing? Revisiting
Let’s talk Direct Indexing, again. Yes, I know I have covered it before but I think it is such a difference maker for high-income earners who are accumulating assets in Taxable accounts that I would be remiss to not talk about it every so often. It is just under a 3-minute read.
I feel as though I should take a moment to refresh on what exactly Direct Indexing Is. The TL:DR (Too Long: Didn’t Read) version is you are building out your own portfolio that holds individual stocks and bonds. Your newly personalized portfolio can be designed around certain themes. They may include everything from Tax-Efficiency to Religious Compliance (Sharia Law portfolios is one example) to a portfolio that excludes companies with poor Environmental ratings. Again, the key here is the portfolio is designed around your personal goals and includes individual stocks and bonds.
I am going to focus on Tax-Efficient Direct Indexing models as this is what I use primarily within my practice, although the Sharia Values portfolios fascinate me.
To give a better understanding of my Direct Indexing models we need to go through the evolution of investment products.
First off are actively managed mutual funds. This type of product is a bunch of individual stocks (in my example here I am not talking about bond mutual funds) chosen by a team of professional money managers. They then measure themselves against an index they often design themselves. Mutual funds were great when first created, however, they are not the most efficient or effective investment product. They lack tax efficiency, nearly all of them lag behind the long-term performance of their respective indexes, and are damn expensive.
Next we have Exchange Traded Funds, better known as ETFs. These are stripped down mutual funds. There is no active management, they are built to replicate their respective indexes, are more tax efficient, and costs are much more reasonable. Their performance is going to be consistent with whatever the index does. Yes, there is not much chance they will have a great year of outperformance like a mutual fund, but at the same time they won’t be like Large Cap Mutual Funds where 90%+ of them underperform the index on a 10-year basis.
Before we jump into my Direct Indexing portfolios, I want to share some history with you. In 2020, the S&P500 had total returns of just over 16%. 60% of the holdings (roughly 300 companies) had positive years. However, 40% were down for the year. Wouldn’t it be nice if you could sell those 200 down companies and grab some tax losses, which still allowing those companies who were doing well to continue to do well? With an ETF this is not possible. However, with Direct Indexing this option is now on the table.
A Direct Index model replicates an index, but with individual stocks and bonds. Let’s focus on a Direct Index portfolio that is designed to replicate the S&P500. My S&P500 Direct Index Portfolios have 150 stocks in them and still have a high correlation to the overall index. The example I use is if you are holding Lowe’s Home Improvement and it is down, you can sell Lowe’s and buy Home Depot to maintain portfolio integrity while also grabbing those tax losses.
Direct Indexing has been around for years, but the price to enter was high. Both in asset levels and costs. Fortunately with technological advancements both of these thresholds have been brought down. The funny thing is some of my Direct Indexing portfolios are cheaper to run than ETF portfolios. Why? Because once you buy the stock there are no ongoing expenses, like there are with ETFs. Plus, most platforms don’t charge trading fees anymore.
Two last points, I promise.
First, what sort of benefit do my high-income earners reap with Direct Indexing. Well, tax-smart investing can add roughly 1% to a portfolio’s return year after year. I don’t know about you, but an additional 1% a year sure can compound. And I am probably conservative with that 1% number as one client had a 5% tax-savings advantage in 2022, which was a volatile year and another client is already up 1% this year.
Next, the one downside I see with Direct Indexing. Eventually you will have a portfolio that is full of stocks that are only up as you have sold off all the losers. However, these can then be sold at a lower Capital Gains rate. To me, this is a good problem to have. Or as we say in my household, a first world problem.
Hopefully this wasn’t too technical. If Direct Indexing is something you want to learn more about, just send me an email to dan@forwardthinkingwm.com.