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Do any HumbleDollar readers use direct indexing? (If you have to ask what that is, you are not likely using this.) If you are either using this relatively new financial tool, or if you seriously considered it and made a reasoned decision not to use it, I’d appreciate hearing from you.
My personal situation is an overallocation to cash (55%) caused primarily by selling out of a low-basis ETF that created an overconcentration in tech stocks. As we continue to sell out of that position while considering retirement in the next few years, we have the opportunity to direct index and harvest capital losses to offset additional capital gains.
I have an annual membership (free in 1st year) with Range Investments that offers direct investing at 12 -22 basis points, which will likely continue to drop in price in future years. It’s very tempting to get the loss-harvesting benefits in the first several years of this strategy, but the continuing drag of the slightly higher basis points in later years – in comparison to total market ETFs at 3 – 5 basis points – is giving me some pause.
Here’s a Gift Article for the May 16 Wall Street Journal piece Stock Gains Without All the Taxes? How the Hottest Trade on Wall Street Works.
I do direct investing, but not using a financial product. Rather I have a list of 25 companies and I invest approximately equal dollar amounts in each one. This is a form of direct investing because I have an “index” that I am buying directly. There are various benefits to this:
1) It is like the Dow Jones industrials, but a different set of equities, which I have selected based on my preferences regarding fundamentals, diversification, and analytics.
2) Because I own each equity directly I can select shares to sell based on tax considerations. This is a form of heightened tax efficiency.
3) Abitragers regularly skim money off the market. Direct investing enables me to keep some of this money through active trading strategies.
4) While past results are no guarantee of future performance and DI will not exactly follow any index, this strategy has over 1,3, and 5 year horizons provided lower risk and higher return than owning a total market fund.
5) Obviously there are no management fees, but equally obviously I must make the management decisions. The size of the portfolio and the value of my time influence whether this is a good strategy.
I’m familiar and have been curious about it for a few years. In fact there’s a new article (today, I think) in the Wall St Journal about the next-gen of this, as given the tear of the market lately there are fewer ‘losers’ to sell to offset the wild gains by the tech high flyers. I’ve not (yet) pulled the trigger on this, but it’s a consideration. I’d personally only do it in a system intended to mirror a main indices like the S&P 500 vs some other sector. But ultimately I’m trying to sort if the juice (improved tax efficiency) is worth the squeeze (fees).
Here are some additional thoughts about direct indexing:
When the direct indexing software sells losing positions, you’re paying a bid-ask spread. When the software buys similar stocks as replacements for those sold, you’re paying a bid-ask spread. These are costs not reflected in the management fee. The tax benefit you enjoy must overcome these additional expenses.
When the software buys similar stocks, you’re likely introducing tracking error because those similar stocks might not be in the index. Your returns will no longer mimic the returns of the underlying index.
If personal preferences lead you to filter out certain companies or sectors, you’re no longer tracking the index. You must accept that you are engaging in active management.
If you happen to own the Vanguard Total US Stock Market ETF (VTI) instead of the S&P 500 ETF, would you (or could you) employ direct indexing? VTI holds 3,494 stocks. It would seem that an attempt to directly index this fund would be overwhelming. Maybe direct indexing by its nature, is best suited to funds tracking indexes with relatively fewer constituents, like the S&P 500.