How Direct Indexing Could Save You Money On Taxes With Adam Cmejla (EP.187)

0:28We all need to make smart decisions with our money. was recorded with my friend Adam Shmela on his podcast, 2020 Money. In that conversation, we take a deep dive into the future of investing, specifically how direct indexing compares to mutual funds and ETFs. We also touch on tax strategies, portfolio planning, and why aligning investments with your long-term goals is so critical. Now, make sure to stay tuned until the end because I share something new that we're working on here at PlanCorp, something that I haven't even really had the opportunity to talk about on my own platform yet. And if you find some of the things that I'm saying interesting, I would love to have a conversation with you to tell you a little bit more about what it means and what it looks like to be a client at PlanCorp.

1:16There are links in the show notes at the long-terminvestor.com. And you can also book a call with me by visiting callwithpeter.com. Big thanks to Adam for hosting this conversation, and I hope you enjoy this episode as much as I did.

1:33Welcome back to another episode of 2020 Money. Joining me on the show today is Peter Lazaroff, Chief Investment Officer of PlanCorp, and also one of the members of my mastermind group. Peter, thank you so much for being here. I appreciate you, man. Let's talk about something that I think is becoming a little bit more popular. It's been around for a while, but I think as technology on the investment landscape has continued to improve and become more efficient, there are more and more people, advisors, investors alike, talking about this idea called direct indexing. And for longtime listeners of 2020 Money, yes, I am taking a little bit of a, dare I say, right turn because out of the 300 plus episodes of 2020 Money, I can probably count on two, I might need three hands, the number of episodes that we've done that have been directly related to investing, period, full stop.

2:26There's obviously no shortage of shows out there. Peter's show is a great one to consider. Listening to, not consider it, go listen to it. I don't know why I gave any sense of hesitation there. Just go ahead and stop the episode right now and go to my show, The Long-Term Investor, then come back and listen to us. Then come back, if you feel like it. Go listen to Peter's and then come back here if you feel like it. In all seriousness, we don't do a lot of episodes on investing because again, candidly, our angle has been how to utilize the business and profession of optometry to plan life on purpose and utilize that to build wealth, protect your wealth, grow your wealth.

3:04But as longtime listeners know, I'm a fan of saying that your optometry practice is two unique and distinct things to you. It is a conduit for cashflow. And it is also an asset that builds enterprise value on your personal balance sheet with the intention at some point, I would assume that every practice owner listening is going to want to sell their practice for a gain. An investment or an optometry practice is an investment. It is a company that we own and we should be able to sell that business for an investment. One of the byproducts that happens whenever we sell any investment, whether it be a business that we own, a stock that we own in a brokerage account, a mutual fund, an ETF, a bond, whatever investment that we own, what are the two certainties in life?

3:46Death and taxes. And so we're not talking about death here, we're talking about taxes. And so to bring this back full circle to what I mentioned in the beginning, the direct indexing approach, while it's been around for a long time, has seemed to pick up a little bit more steam. And it goes by a lot of different names, direct indexing, SMAs. Those are the two big ones. They were SMAs or separately managed accounts for like for institutions, big, big institutions, like decades even. But yeah, you're right. The technology has gotten to a place where the costs have come down where the average investor can access it, which is crazy.

4:24As this has become more popular, let's just give some context and backstory to what is direct indexing. Let's just start there and give a basic definition of what it is and how it's different than the quote unquote traditional investing that your average investor would be used to. Let me give you the one sentence. Hey, your audience probably wants to be able to tell time. That's what I'm going to say first, and then we'll get a little into how the watch works. But to me, direct indexing is like owning a mutual fund or an ETF, but with just one person. Imagine you and me own shares of a S &P 500 index mutual fund.

5:02The mutual fund is going to combine our funds into a single pool of assets that own the underlying securities of the S &P 500 with the explicit goal of tracking that index. And so you and I in the fund together, as well as thousands of others, we're going to share all the costs of that fund. And those costs are the commissions of buying and selling the individual stocks that are within the mutual fund. It's the bid-ask spreads. It's the market impact. It's taxes. And I think the taxes is the really important piece because when mutual fund managers tend to deal with investors in cash, it means that they're selling their securities to raise cash for investor redemption.

5:42So again, you and I are in a mutual fund together. I need to withdraw or I need to sell something either because I'm rebalancing or I'm using my portfolio to fund lifestyle expenses. And the mutual fund manager just has to raise cash. And just like when you and I and our clients have to raise cash from their portfolio for any number of reasons, their capital gains. Each day, mutual fund managers are doing this. And so as you continue throughout the end of the year, what happens is that you are given at the end of the year, a tax bill, you're given a capital gain distribution, not always in a year like 2022.

6:19When markets were down, those funds were able to sell things at losses, and minimize that capital gain exposure. If a lot of your listeners own the total stock market index, or an S &P 500 index, there's no doubt that the capital gain distributions are going to be lower than if you own a actively managed mutual fund, but they're still there. With ETFs, and this is where we're kind of getting into a little bit of how the watch works, but I swear I won't go too deep unless you follow up and take me there. The exchange traded fund versus a mutual fund, it's a little different because there's this authorized participant that acts as a middleman.

6:55And basically, if I'd like to buy shares of a S &P 500 ETF, my cash is sent to a brokerage firm that's sent to this authorized participant who basically delivers a basket of securities to the ETF. And so when I go to sell my ETF shares, the ETF is going to send a basket of securities that is going to create the least tax impact for the whole group. That can be a somewhat complicated topic and concept. So let's not even worry about it. And let's talk about what the SMA does. The SMA is a mutual fund or an ETF for one. And you will go to a manager, whether it's a Vanguard or dimensional fund advisors, or I mean, there's dozens of people doing this.

7:37And you give them cash or even cash and securities. Maybe you own Apple or United Healthcare or something for a long time with big gains. And the problem with that is that here's this position that's done really well, but it doesn't strategically fit into your asset allocation. And so you might go to the fund manager and say, hey, I would like the total US stock market exposure. And maybe you give them a million dollars cash. Maybe you give them$500 ,000 cash and some NVIDIA that you hit a home run with or Apple or I always say UnitedHealthcare because I know you're working with optometrists. I historically have worked with a lot of physicians that were for some reason forced to buy United Healthcare early in their career and yet they're still holding it and they made a killing on it.

8:21why would you have an overweight to one company if you don't need it? Why have that single stock risk? Why have that concentration risk? Yeah. And the fund manager will build around it. But again, keep it simple. I'm already getting distracted. Let's pretend we're giving them cash just like you're going out to buy an ETF. If you have the choice of buying Vanguard Total Stock Market Index, VTI, or giving it to a manager to do a direct index, so it's basically they're doing the same strategy, but it's just for you and not for hundreds of thousands of others. You aren't sharing the cost with hundreds of thousands of others, but there's a tremendous benefit in the way that you can manage the taxes so that it is technically lowering the overall costs.

9:02And then it can be very beneficial if you are doing good financial planning around it. Great explanation and very succinct in being able to kind of delineate between mutual funds, ETFs, and then the separately managed account or the index for one. I love that approach because at least I was able to visualize that. I assume the audience was as well. The way that I've thought about this is you're essentially unwrapping the index. You're allowing the investor to own everything that's happening within the index fund. And if that's your approach, if you view yourself as an indexer, this is an approach to consider for your investment philosophy going forward, because from an investment point of view, your investments should be tied to a goal.

9:48And investing without a plan, that's a whole other conversation in and of itself. But everything that we do with our money should have some type of goal attached to it in some type of plan. And that's where there's these two separate lines that I think of that are converging for investors. The one line is their ownership journey in the practice that they own. And then the other line is their investment experience that they have as an investor. And eventually, those two lines will intersect. And my visualization of this mentally is the intersection is the year in which they sell their practice.

10:21In the absence of having any type of capital losses that they're carrying forward from previous years, it's not if it's to what extent the sale of that practice is going to be taxable, how much of that is allocated to the asset side of the sale, how much of that is deemed the goodwill and the long-term capital gain side of this. But there is the tax lost harvesting approach that is part of that investment line that I talked about that somebody can make that decision to tax loss harvest or not. The one extreme angle of it is you are a true buy and hold investor and you never sell ever. You're just DCA dollar cost averaging every month, every quarter, every week, whatever your frequency and cadence is as an investor, you're just investing every single time.

11:06And when you get to the point of retirement, your portfolio is this, you never sold, great, good for you, you embrace the power of capital markets, awesome job, your portfolio is worth X. The next iteration of that is somebody that is still investing in index funds, but they're taking a little bit more active approach as an investor themselves with their portfolio. So they're looking at, I talk about this as what should your pie look like? You want this much to large cap growth, this much to large cap value, this much to international, this much to emerging markets, this much to crypto, to real estate, whatever your asset allocation is.

11:40And you're looking at this in the form of sleeves or the rebalancing approach. So I want my exposure to large cap growth to be X percent. And if it gets over that, I as the investor, not as the fund manager, but I as the investor and the manager of my own portfolio, I'm going to say, oh, I'm a little bit over concentrated here. Hey, let me exercise the fundamental rule of investing. Buy low, sell high. Let me sell some of my gains. Look in my portfolio of ways that I can offset those gains with losses. Is there something that has underperformed in my portfolio? Can I sell at a loss, offset those, and get my portfolio back to the target allocation?

12:19And then there's this emerging approach that, as we said, technology has opened it up to be a little bit more widespread on the direct indexing approach, which allows you to take this idea and this concept of tax loss harvesting. Do you agree with how I teed that up and thought about the different avatars of investors? And can you talk a little bit more about how this direct indexing approach and tax loss harvesting kind of reconcile with each other? I wrote down a couple things as you were talking, one of which has a little bit less to do with everything else. So I'm just going to say it. I want people listening to realize that accumulation is very different than decumulation.

12:59You can listen to podcasts like yours, Adam, or mine. You can read books. And the formula for accumulating wealth is well known and not very hotly debated at this point. Decumulation is very difficult, very personalized, and there there's a lot of mistakes you will make and you won't even know you've made them. Sometimes you will and then you'll kick yourself, but you won't know until you get your tax bill. I feel like index investors in general are some of my favorite people because one, I'm an index believer personally. The one fund portfolio, right? Yeah. If anyone goes to my website, you're going to get this little pop up who's like, how does Peter invest?

13:40I'm even pretty sure there's a howpeterinvest.com URL if you're really curious. But I own one fund. I don't think it needs to be that complicated. I help oversee seven and a half billion dollars. But I feel like for me, simplicity is the answer, in part because I don't have time for myself, I take care of others. And ultimately, good investing is boring. And the way that that used to look was buying a mutual fund emphasis on mutual fund index. Then fast forward to the 90s. And there's this new vehicle called the ETF. And definitively, the ETF is more tax efficient. And if you're plowing dollars into a mutual fund rather than an ETF, please stop doing that.

14:19What I find is a lot of my listeners, they have index portfolios, and maybe they have some of their assets with the manager because they appreciate the financial planning. What you need to realize about direct indexing or a separately managed account, or I'm just going to say SMA from here on out, and hopefully I'm not being overly jargon heavy by doing so, but this is the next evolution of index investing. In 2017 was the first time that cost of these vehicles dropped to a level where I felt like there were a certain type of investor profile that it made sense. And we're talking maybe 35, 40 basis points to get total US stock market access, something that's going to track the Russell 3000, for example.

15:02That's expensive relative to at the time, Vanguard offered the same product for I think four basis points. Now they're down to three, but history lesson. A lot of people didn't like the idea because of the cost. And so we talk again about sharing costs at a mutual fund. Yes, there's the expense ratio. There's also the tax cost. There's also these implicit costs that we would need another two hours to talk about that nobody sees because there's no such thing as free. But again, two hour conversation, we can have another time. That's a deep dive bonus episode for those listeners that I'm kidding.

15:31We're not. That's right. We'll only put it on YouTube, but it'll be on a hidden channel. This is the next evolution. And now you can do direct indexing for depending on the size of assets you're working with and the strategy that you're following, you can do it for anywhere between 12 basis points or 0.12 % and like 0.2%. I think most people are in that range competitively with the big managers. That's not that different than an index fund. And the benefit that you get from a tax perspective is really, really powerful. And let me explain a little bit more how that works. Imagine you go to a manager, Vanguard, Dimensional Fund Advisors, BlackRock, whomever.

16:12And you say, here's a million dollars, I would like the Russell 3000 returns, please. And they say, okay. You say, also, though, I want you to make sure that you get a lot of tax loss harvesting losses for me. I'm cool with the idea that I don't track the index perfectly. If you give me more losses, my personal experience, guiding clients to these dates back to 2017, and the data would support this. These managers are pretty good at tracking indexes, whether you want losses or not. And so they're going to go out and they're not necessarily going to buy all 3 ,000 companies in the Russell 3000.

16:44They don't actually need to. And when you think about it, the top 10 stocks make up 33 % of the index. So right there, the stocks that make up a 10th of the index aren't that important. You can do something through optimization rather than replication. Those are technical terms that the fund managers use, even for their ETFs. There are S &P 500 ETFs that use optimization rather than perfect replication. But they use optimization with SMAs. And so when Coca-Cola is trading at a loss because they had a bad earnings report or something, they can sell Coca-Cola and go buy Pepsi or sell Johnson & Johnson and buy Pfizer or sell ExxonMobil and buy Chevron.

17:24And what you're doing, it's the same concept as when your tax loss is harvesting at the fund level. For example, maybe you're selling your S &P 500 ETF and buying a Russell 1000 large cap ETF in its place. You capture the loss. You sit in this fund for at least 31 days and maybe you rotate back into your preferred fund. Maybe you don't. Dear index investor who is listening to us, if you want to capture losses, you have to wait for the entire index to be down. Adam, I can send you something for the show notes that if you want to use graphically. Graphically, it's not like a Peter Lazaroff original.

17:58It comes from an outside provider, and it just shows you what percentage of the index is down in a given year, and then what was the market return that year. And so you see in up years, even 40 % of individual stocks are typically down at some point. That's a tremendous opportunity to tax lost harvest. And I wouldn't say we're dancing around the fact that these are awesome from a tax planning perspective. but dear index listener, imagine you own an optometry practice perhaps and you think that you might sell that practice. You know that a capital gain is coming down the pike. And so you could choose to continue to plow money into ETFs and mutual funds tracking the whole index and just be prepared to pay that capital gain bill whenever you sell the practice.

18:43Now, maybe you aren't gonna sell the practice and we can touch on that too But ultimately, why wouldn't you be banking losses to reduce the tax liability? And yes, maybe you're paying, I'm just going to say a random round number, 15 basis points more per year. Let's do the math on like a million dollar capital gain. I'm pretty sure you're going to pay more than that. Not everybody knows that they're going to have a big capital gain coming down the pike. And so when I think about the clientele that I work with, which is less focused than your practice, you have deep expertise in this area. and I know your practice well, it's why your clients love you, it's why you're respected in space, it's that not everybody has a big capital gain coming down the pike.

19:25And some people do and some people don't, but let's imagine that you don't have a capital gain coming down the pike. Why are these tax losses valuable? Sure, you can write off$3 ,000 of income every year. Great, but not that interesting. It's amazing that number has not increased. It's been 3 ,000 for how long? The one number that never gets an inflation rate. Everything else is getting inflation indexed. What the heck? Come on, guys. I'm not a political person, but come on, let's do that. This is going to be my political campaign. I believe teachers should not pay taxes. And I'm going to now run on a second thing that the capital loss forward should go up.

19:59Amen. With that aside, ultimately, even if you don't have a big capital gain coming down the pike, you are going to rebalance. Life is uncertain in the sense where you can't predict what sort of gains you might come. And if you're going to live off your portfolio one day, that's going to have gains. And I feel like this goes, oh, I get to full circle. This is exciting. That goes back to why accumulation and decumulation are so different. So you're in retirement. And what you have the day you retire is what you have. And tax management is extraordinarily difficult. You can't make taxes disappear unless you did good planning in advance.

20:35And so there's a lot of planning, obviously, with moving money around, whether that's like Roth conversions or the way that you charitably give or accelerating or deferring income, especially like the end of your career to try to like spread out tax impact. I don't think anybody's going to be upset getting to retirement, sitting on a whole bunch of losses that they can then keep the gains lower. It can make a Roth conversion strategy more effective. It's really endless. And so I think that's the big benefit. There are other reasons that you can direct index. But to me, that is why this is the next evolution.

21:07I think that you should take note that literally every major asset provider, I said Vanguard, dimensional BlackRock, but it goes deeper. It's Goldman, it's Morningstar, it's American Century. Everybody is doing these because it is the next iteration from mutual fund to ETF to direct indexing. And one last thing I'll say, and then I'll take a breath. I think in general, when there are new ideas, they can be difficult to wrap your head around. What is the risk, in my opinion of this approach. The risk, I suppose, is that at death, the step up of basis goes away, which to be clear, is a risk for everything.

21:48And the natural outcome of a portfolio where you're harvesting losses and holding the gainers means that you're going to have a very low basis portfolio. On the other hand, it is going to be diversified. On the other hand, there are some really, really cool stuff you can do with a super mature SMA 10-15 years in to simplify it. But that would be the big risk, in my opinion, is that at death, you have 500 to 1000 holdings that just shows up as one line item on the statement. I've watched people go through their estates with it. It's not difficult to deal with at all. But if the step up in basis were to go away, you are in this sort of wrapper for life.

22:25But again, I'm of the opinion that this sort of wrapper is the future. I do want you to unpack the super cool thing that you can do for a matured SMA. I am curious to hear your thoughts on that. I think, to your point, the hesitations and reservations that we have along anything new, our natural instinct is to be cynical and possibly skeptical about it. It's like, what's the catch? This sounds great. I get to own the index. To be clear, we're not saying it's free. It's not the exact same cost as an index fund. There are explicit and implicit costs in that trading, tracking error, bid-ass spreads, etc.

23:03But everything in life from a financial planning standpoint is about weighing the benefits and exchanges of the decisions that we make. And to your point, eventually the portfolio becomes the plan. One of my episodes that I did a long time ago, years ago, was the four levers that you can pull towards your financial independence. How much you save, the delta between now and when you want to retire, how much you spend in retirement, and the rate of return on your investment. Basically, it's the time value of money equation. Let's just call it what it is. But to your point, Peter, when you get to that point of capitulation where you're now on that summit of climbing a mountain, you still got to get down.

23:40And that can be the more complicated part of planning is the decumulation mode as opposed to the accumulation mode. So when the portfolio becomes the plan, that's where some people might be thinking, well, so I'm going to do this direct indexing thing or this SMA approach, again, we're using those words interchangeably, I'm going to have 1000 positions, my statements going to be 150 pages long, my 1099 is going to be 900 pages long. I don't want to sign up for that. That sounds complicated as heck. And then to your point, the hard part for us to all think of is cognitive decline. And as I age, like who's going to take over this, if I am investing myself, is my wife or my husband going to be able to do this?

24:21How do I find somebody to manage this? Beginning with the end in mind, I don't want to create something right now that sounds great only to have it be a challenge and an obstacle down the road. I'm not going to dispel any of it. I think it's good that we're talking about it. I think the risk is perception of more complication. The thing is that, again, it's a different wrapper. We do tax returns at Plaincorp. We have clients who are in SMAs. Yes, they have very, very long 1099s that they download and then they upload and then they never see them again. If you're doing your own taxes, please stop.

24:54Especially as a practice owner. I mean, if you're doing your own taxes as a practice owner listening right now, do not pass. Stop listening to this episode. Don't even go listen to Peter's episode. Hey, find a CPA. I'm just kidding. No, it's okay. Get that off your plate. I agree. The risk is that you're introducing a little bit of complexity, which I'm pretty anti-complexity. And so I think in general, that to me tends to be the thing where I get the most questions. Now that the cost has come down, I get less questions. And let me be 100 % clear. If I had a million dollars cash today myself, which I do not, it would be going into a direct index.

25:33Full stop. Take that for whatever it's worth. As someone who all my money is really just in tax deferred stuff now, I'm being candid about it. Because I tell you, I publish it everywhere. And again, I think the URL is howpeterinvest.com. The reason I say all that though, is that to me, it's a no brainer. I used to say that there were better use cases than not. Let me talk about people who maybe are not a good use case. Not a good use case is that you're in a low federal income tax bracket. You don't have any capital gains, whether it's from a liquidity event, or whether it's from most of my assets are not going to come from liquidating a taxable portfolio.