What Is Direct Indexing? (EP.95)

0:28We all need to make smart decisions with our money. streaming preferences, or insurance policies. So why should our investments be any different? With direct indexing, investors can create custom portfolios based on their specific goals, values, and preferences, rather than relying on pre-packaged ETFs or mutual funds. In this episode, we'll be exploring how direct indexing differs from ETFs and mutual funds, the ways direct indexing can boost after-tax returns, and the ideal types of investors who could benefit from direct indexing. As always, you can find detailed show notes at thelongterminvestor.com, as well as additional resources to help you make smart decisions with your money.

1:10Let's dive in. Direct indexing goes by a few names these days. It's not just direct indexing, it's personalized indexing, it's custom indexing. But they all make use of something called a Separately Managed Account, or SMA. SMAs have been around for decades, but they've become increasingly popular in recent years as advances in technology have made it easier and more cost effective to manage customized portfolios, as well as the shift in investor preferences toward more individualized investment solutions. So direct indexing is just a term used to describe the use of an SMA to build a portfolio of individual stocks that mimic the composition of an index, such as the S &P 500 or the Russell 3000.

1:56To really understand how direct indexing works, though, I think it's helpful to start with how it differs from traditional investment vehicles such as mutual funds and ETFs. Imagine you and I each own shares of an S &P 500 index mutual fund. The mutual fund combines our money into a single pool of assets that owns the underlying securities of the S &P 500 with the explicit goal of tracking that index. All costs of the fund are shared between all investors, and those costs include things like commissions, bid-ask spreads, market impact, as well as the opportunity cost of holding cash or the cost of borrowing with lines of credit, and taxes.

2:38Taxes are particularly important in this conversation because mutual fund managers tend to deal with investors in cash, meaning they must sell securities to raise cash for investor redemptions. So each day, a mutual fund manager is going to buy and sell securities in response to investors' cash flows and the rebalancing needs of the fund. And whatever taxable gains and losses are accumulated throughout the year are distributed to shareholders at the end of the year via a capital gain distribution. Now, let's say I need to sell all my shares of our S &P 500 index mutual fund, but you continue to hold the fund throughout the year.

3:17Again, because mutual funds tend to deal with investors in cash, they must sell securities to raise cash for my redemption. But you are stuck with the capital gains incurred as a result of selling securities to generate cash for my redemption. And this is really the big downside of a mutual fund. If I sell my shares in our S &P 500 index mutual fund, I get my cash out while you and others are stuck with the capital gains realized when I redeemed my shares. Exchange traded funds or ETFs are a bit different because they have what's called an authorized participant acting as a middleman in the transaction.

3:56So again, let's imagine that you own an ETF tracking the Russell 3000 index. And I decide I'd like to buy some shares of that same ETF. My cash is sent to a brokerage firm acting as an authorized participant who then delivers a basket of securities to the ETF. And when I go to sell my shares, the ETF sends the brokerage firm acting as this authorized participant a basket of securities and the brokerage firm then delivers me the cash. And because the fund is delivering a basket of securities at redemption rather than liquidating the securities for cash, my exit from the ETF doesn't leave the remaining long-term shareholders with a tax bill.

4:37The ETFs minimize the effect of investors' activity on long-term investors is one of the primary benefits of the ETF structure. But what about separately managed accounts or SMAs? Well, unlike a mutual fund or ETF, an SMA allows an investor to directly own individual stocks that track a specific benchmark, such as the S &P 500 or the Russell 3000, which we've already mentioned. And because you have direct ownership of the individual securities, it allows for some unique benefits that aren't possible with an ETF or mutual fund wrapper. And the way I see it, there are really two primary benefits of direct indexing over ETFs and mutual funds.

5:17And the first is the ability to customize the portfolio based on your objectives and preferences. For example, if an investor is concerned about environmental, social, and governance issues, ESG issues, they can create a portfolio that reflects their values by excluding companies that do not meet their ESG criteria, or they could overweight companies that do meet their ESG criteria, or some combination of both. Similarly, there are a lot of factor funds available off the shelf, but direct indexing allows you to create custom factor tilts to certain characteristics like value, momentum, or profitability.

5:54Another useful form of customization comes into play for people who receive equity compensation from their employer. In these instances, it's easy to exclude that company or even the entire sector from your portfolio so that you don't further concentrate your financial well-being to a single company or market segment. Beyond these customization benefits, the other significant advantage of direct indexing is the potential to boost after-tax returns. Direct indexing enables investors to take advantage of tax-loss harvesting opportunities by selling losing positions and buying similar stocks to maintain their exposure to the market.

6:31For example, maybe your SMA manager sells Coca-Cola at a loss and buys Pepsi, or sells Johnson & Johnson at a loss and buys Pfizer in its place, or sells ExxonMobil and buys Chevron. You get the point. Unlike an ETF or mutual fund, which requires the entire index to be at a loss in order to perform tax-loss harvesting? Investors can harvest losses at the individual security level within an SMA, which can boost those after-tax returns. You might be wondering, are there really that many losses available for harvesting, given that the stock market is up most years? Well, in a recent Vanguard piece that I'll link to in the show notes, they show that the S &P 500 was up 9.76 % in the fourth quarter of 2021, and yet there were still 133 individual companies in the S &P 500 that lost value during that time.

7:24And according to that same Vanguard piece, they found that daily tax loss harvesting boosted some investors after tax returns by 1-2 % or more. Sound too good to be true? Well, like anything good, there is a downside. For a fund that's constantly selling the losers at a loss and holding the winners with gains, eventually you'll have what looks like a very low basis index fund with a higher expense ratio than you'd pay for an ETF or mutual fund tracking the same index. It's a valid concern, but it's not terribly difficult for the compounding tax benefit to offset the cost, especially now that the cost of SMAs have fallen so dramatically.

8:03For a long time, SMAs were only cost-effective for ultra-high net worth investors. And when you think about it, just being able to afford to buy the stocks necessary to approximate a given index's performance was a big barrier to entry. But also, regularly rebalancing a portfolio of hundreds, if not thousands of stocks, so that the portfolio continued to track the desired index, was also difficult, time-consuming, and costly. But several developments have helped make these strategies far more economical for a larger group of investors. The biggest change, of course, being technology. And it's these software innovations that have automated processes such as regular scanning for tax-loss harvesting opportunities and rebalancing that has really brought down operating costs and not only reduced the cost of the SMAs, but reduced the minimum investments required to use such accounts.

8:55Other important developments include brokerage firms offering commission-free trading, which dramatically reduces transaction costs, and the ability to buy fractional shares, again, making it more affordable to fund an SMA tracking a given index. That said, not every investor will benefit from direct indexing. Typically, direct indexing is going to be best suited for a handful of use cases. For example, investors in a higher federal income tax bracket and or has lots of capital gains to offset could definitely benefit from the tax loss harvesting capabilities of direct indexing. Also, investors with strong ESG convictions or preferences that might require more precision than could be achieved through a prepackaged ETF or mutual fund, that group of investors also might be good candidates for direct indexing.

9:45And then you have investors who are seeking specific factor exposure, such as value or profitability, but need to build around existing holdings rather than liquidating their whole security to buy a factor product off the shelf. And in a similar nature, you have investors with concentrated positions who can use direct indexing to build completion portfolios around large existing stock holdings. This allows investors to diversify their portfolios while maintaining exposure to specific stocks or sectors they may want to hold for personal or financial reasons. Another group of investors who can benefit from these strategies are investors that receive equity compensation or whose livelihood is closely tied to the health of one segment of the economy because they can really benefit from excluding that exposure from their portfolios.

10:32This goes for both people working at publicly traded companies as well as business owners who have a privately owned business because not only is their financial well-being likely tied to a specific area of the market, but using direct indexing to bank some tax losses to use at the time of their eventual exit from the business is a really common use case for direct indexing. In conclusion, direct indexing can be a powerful investment strategy that offers a level of customization and tax efficiency that may not be possible with a traditional mutual fund or ETF. Again, if you want to learn more about this, you can go to the show notes at thelongterminvestor.com.

11:12As always, thanks for listening. And until next time to Long-Term Investing.

11:35Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.