Today on Equity Compensation Guidebook we're going to talk about another tax-smart investing concept, direct indexing. 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 exchange-traded fund (ETF) or a mutual fund.
The concept of direct indexing has been around for years and it provides many benefits which we'll cover in this episode. Up until now, it hasn't been available to the masses as it was expensive to administer. The investment companies that provided direct indexing had to set high minimums which put it out of reach for many investors. Fortunately, technology has advanced enough to provide more access to the continuously increasing interest in direct indexing.
You will want to hear this episode if you are interested in...
- The concept of direct indexing [1:27]
- Picking on mutual funds [3:26]
- Taking out the middleman with ETFs [4:44]
- How direct indexing can help you be even more tax-smarter than ETFs [6:49]
- Flexibility that puts you in control of the companies you invest in [9:26]
- This week’s FLASHBACK [11:23]
Pitfalls of Mutual Fund & ETFs
Mutual Funds were cutting edge when they were created what seems like forever ago. The goal was typically to create a mutual fund that was comparing itself against a benchmark or an index 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 out-performance tough. First, they're expensive, less expensive now, but still more expensive than ETFs. They also have the capability of creating a big tax headache via a tax bill. Finally, when selling mutual funds, they do not get priced until the end of the day. The short version is they're not as agile as ETFs or individual stocks.
Now, ETFs were created to sort of take out the middleman. Exchange traded funds typically mean instead of having an expensive manager who is trying to outperform an index we will just try and match the performance of the index. This helps keep costs lower as there is less trading and not as much overhead. They're much more tax-efficient and they trade like a stock. A bonus with ETFs is you can do some nice tax loss harvesting work.
Being even more tax-smarter with flexible direct indexing
We've evolved from mutual funds to ETFs and now we’re at the pinnacle...direct indexing! Direct indexing can get even more tax efficient and tax smart than ETFs. An example is that AAA investment company created a direct index of the S&P 500. Their direct index product only holds 80 individual stocks instead of 500. These 80 stocks create a model that has a high correlation to the full S&P 500 index.
Let's say you bought an iShares S&P 500 ETF. Some companies in that ETF may be up since you bought it and others will be down but the total value of the ETF is up. You can NOT get super surgical with that ETF and sell those individual positions with losses to help lower your tax bill. This is where direct indexing comes into play. You can now get down to each individual holding to do some tax-loss harvesting. You sell those positions with losses for tax purposes and then use the proceeds to buy a similar, but not identical, holding. For example, go in and sell the Lowe's position, grab that loss, and then go buy something like Home Depot so you still have an overall index with a high correlation to the S&P 500. This is a simple breakdown and you can get a little more detail when you listen to the episode.
This week’s FLASHBACK: My safer than a Jeep motorcycle
I mentioned in a previous episode how I decided not to buy a Jeep because it felt too dangerous. And instead, I decided to buy a motorcycle, which is of course, much less dangerous. But it was something that I always wanted to own. Fortunately for me, the stars were aligned in college that I was able to check this item off the old bucket list the summer I worked at a furniture store. I had worked my butt off and banked more hours than all but one person and it landed me a huge cash bonus. Since that money was unexpected— and not needed for regular bills or tuition— I was free to spend it in any way I wanted… and I wanted a motorcycle!
A friend of mine had a motorcycle and had been riding since he was five years old. I told him I wanted a sportbike and helped me find a good used one. I bought a Katana 600. I think it was a Suzuki. I don't even remember at this point. I bought it in early fall when they were cheaper. I couldn't even ride it so my friend had to test it out for me. Once the weather broke in spring I rode it all the time! Ultimately I sold the bike about a year and a half later. I sold it in the spring to get top dollar and I think I sold it for about a hundred dollars less than I paid for it. I used the proceeds for a computer and a printer as I headed off to grad school.
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.