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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.
DI is a lot more work than most want to spend on managing their finances, especially in retirement. Way too complex to take into late retirement. A direct investor is likely overfunded or will be, you have better uses of your time unless finances is your hobby. DI will not make or break a retirement portfolio, an optimization strategy at best.
Each week I learn from Humble Dollar. On this subject I needed more explanation which I found in a summary. This may help explain more as it did for me. Sure hope this helps many.
What is direct indexing accounts
A direct indexing account is a personalized investment strategy that gives you the benefits of an index fund (like the S&P 500 or Nasdaq-100) but with a massive twist: instead of buying a single share of an ETF like VOO or QQQ, you directly buy and own the individual stocks that make up that index. It is typically set up as a Separately Managed Account (SMA) through a wealth advisor or a major brokerage platform.
To understand why investors use them, it helps to look at the contrast between a traditional fund and direct indexing, along with the specific benefits it offers.
The Difference: ETF vs. Direct Indexing
Why Do Investors Use It?There are two primary reasons why someone moves capital into a direct indexing account:
1. Aggressive, Continuous Tax-Loss Harvesting (The Big Draw)In a standard taxable account, you can only harvest a loss if the entire index fund drops. If the S&P 500 is up 12% for the year, your ETF is up, and there are no losses to harvest.
With direct indexing, you own the individual components. Even when the S&P 500 is having a banner year and is up overall, there are always 50 to 100 individual companies inside the index that are losing money at any given moment.
2. Portfolio CustomizationBecause you own the raw ingredients of the index, you can filter things out.
The Trade-OffsWhile direct indexing sounds ideal, it isn’t a perfect fit for every portfolio due to three main constraints:
The SummaryThink of an ETF as buying a pre-made cake from the bakery, while direct indexing is buying all the flour, sugar, and eggs separately. It takes more work and costs a bit more to organize, but it allows you to change the recipe and use the scraps to offset your taxes.
This 2023 article by Allan Roth summarizes direct indexing’s pro and cons better than most. His conclusion?
“Direct indexing is generally not as good as buying broad ultra-low-cost index funds. That said, it could be beneficial in certain circumstances:
· You want to donate to charity in a few years so you can harvest the tax loss and then donate the appreciated securities to the charity, thereby never paying taxes on the appreciation.
· You currently have large taxable long-term gains at the 23.8% marginal federal tax rate (20% +3.8% investment income tax) but soon will be in a lower rate.
· You are in a high tax bracket but have a very short life expectancy and the kids will soon inherit the money with a step-up basis.”
Roth ended with this: “Direct indexing is good. It’s just generally not as good as owning broad ETFs.”
Thanks to all who responded. Please update here if you use direct indexing and learn something worth sharing.
After reading a few of the comments, I would like to clarify that direct indexing, or separately managed accounts do not create any extra paperwork in preparing my annual income tax returns. I receive a 1099 just as I would for any other similar account. As noted, the 1099s are very long but you do not enter every position. The provider totals everything up and you only need to enter the summary data. These investments are not for everyone, but in the right situation can be very beneficial. I have not paid any capital gains tax for 10 years.