A New Investment Strategy in the Marketplace
If you are an investor who follows the financial media, amid the stories of gloom and doom you have likely heard of a new investment strategy being offered by many financial institutions: “direct indexing”.
The challenge associated with any new investment product, like this one, is determining if the instrument is suitable for you. The objective of this article is to help you understand direct indexing, answer the most frequent questions, and guide you in assessing whether the approach warrants further consideration for your specific circumstances.
What is direct indexing?
Direct indexing is an investment strategy which combines characteristics of ETFs (exchange traded funds) and separately managed accounts.
An ETF is a passive investment strategy, attempting to track a segment of the market. The segment could be an index such as the S&P 500, Russell 1000, or the Bloomberg Aggregate Bond Index. ETFs could also attempt to mimic the results of a sector, industry, geographic region, country, or socially responsible index.
Separately managed accounts are investment strategies operating in many of the same market segments as the ETFs listed above, however the objective of those strategies is to outperform the respective index. Investors allocating to a separately managed account own the underlying securities within the designated market segment. A large cap growth strategy will own individual technology stocks, and a municipal bond strategy will own individual bonds of cities, states, or counties. The investor is paying for active management; therefore, the expenses are typically significantly higher for a separately managed account compared to an ETF.
An ETF investor will own a single security (however they will indirectly own the companies comprising the index). A separately managed account could directly own hundreds of securities.
Direct indexing is a passive strategy attempting to track a segment of the market, rather than outperform its respective benchmark. The direct indexing approach will own individual securities, as opposed to offering the bundled approach of an ETF. So why would an investor sign up for market matching performance with a slightly higher cost (relative to an ETF)?
Benefits of Direct Indexing
While direct indexing has two key features which have captured the attention of advisors and investors, the potential tax savings is easily the most popular. Direct Indexing leverages technology to perform tax harvesting, realizing losses to offset gains. Investors in the top tax bracket, like many physicians, may find this feature extremely valuable. Even in a year when a broad index offers double digit returns, a direct indexing investor is typically presented with the opportunity to realize losses. In 2021, the S&P 500 was up more than 27%, however over seventy stocks within the index finished the calendar year lower.  The benefits of a direct indexing strategy are more apparent in a down year such as 2022 when most sectors finished in the red. Investors who realized gains early in 2022 on investments they held for multiple years during the recent bull market, could have potentially saved thousands in taxes by offsetting gains in a direct indexing strategy. An ETF would not provide the same opportunity in the prior scenario.
Customization is also a popular feature of direct indexing. Consider a physician who does consulting work for a large publicly traded medical device company. If the physician received stock compensation for their services, and the company was successful, significant wealth may have been accumulated in the stock. The doctor can elect to exclude the medical device company from their directing indexing investment. A stock can typically be excluded for any reason, including environmental, social, and corporate governance (also referred to as ESG). In fact, most companies offering direct indexing have ESG-focused strategies available to investors.
Who should consider the product?
Optimal candidates for direct indexing are investors who have accumulated significant assets in non-retirement accounts. Direct indexing is ideally used as a component of a larger investment strategy. While an investor can find firms offering solutions with lower minimums, we think an investor should have at least $100,000 in a non-retirement account to truly benefit from the strategy. An account holder is likely to own between 250-600 individual securities upon implementation, therefore position size can be exceedingly small. Realizing dozens of $8-$10 losses is not necessarily practical.
The higher an investor’s tax bracket, the greater the benefit of tax-loss harvesting. One can offset 100% of capital gains by realizing capital losses and can offset up to $3,000 in income according to current tax law. Effective tax management can improve one’s net return. Research has attempted to quantify the value provided by active tax harvesting. A study by Terry Burnham, a finance professor at Chapman University, evaluated a tax-loss harvesting strategy owning the 500 largest U.S. stocks by market cap from 1926-2018. The results suggested the tax managed approach would have added returns of 0.82% annually greater than an approach which had passively owned the companies.  Tax rates of 15% were used for long-term capital gains and 35% for short-term capital gains.
Today’s top rates are higher than those assumed in the study (long-term capital gains rates max out at 20% and may be subject to a 3.8% investment income surtax). An argument could be made 0.82% of added value annually could approach 1% if today’s rates were applied to Professor Burnham’s research. Vanguard performed a similar study, with like findings.
Investors interested in customizing their index are an additional group who could be candidates for direct indexing. The ability to exclude securities may provide value to individuals with unique circumstances or preferences.
What are the drawbacks?
When comparing ETFs to direct indexing, the latter will be more expensive. Index ETFs have operating expenses ranging from 2 to 20 basis points (on average). As of the time of this article, direct indexing strategies were charging 25-40 basis points (0.25%-0.40%) for their service. An ETF will be the better choice for most investors in a tax advantaged account, simply due to cost.
Individuals using direct indexing are also adding complexity. Not only is one buying 300-600 securities, but one will also need to be prepared for an overwhelming number of trade confirmations and shareholder documents. Tax returns may become more complicated, and an investor could be required to coordinate the tax-loss harvesting of the direct investing account with their other investments. Leveraging an advisor to help with this process and selecting a custodian who will aggregate communication is critical.
Investors who are customizing their index may experience tracking error — the divergence between the price behavior of this strategy versus its benchmark index. Returns will drift from the benchmark index if securities are excluded, or tax harvesting is performed frequently. The difference in returns vs the target index may be small, however divergence is a potential drawback.
If you are self-directing investments, another consideration is how you will oversee a mature direct indexing portfolio. A time will come (likely several years in the future), where all losses have been realized and the portfolio consists exclusively of gains. You will eventually own an expensive index fund and will need to ask yourself if you would be interested in managing a portfolio of several hundred stocks.
Making the decision to use direct indexing is no different than the process to evaluate any other investment. An investor’s tax bracket, net worth, risk tolerance, composition of assets, interest in customization and desire for simplicity are all factors in determining if the approach is appropriate for you. Potential tax benefits are typically the driving factor behind implementing a direct indexing strategy.
Realizing gains from existing investments may not be an advisable method of funding a direct indexing strategy. Investors with cash available to invest in a non-retirement account, or individuals who have realized losses and are looking to reallocate capital, are typically candidates for direct indexing.
Direct indexing is not appropriate for every investor. Work with a professional advisor prior to implementing this strategy or to obtain additional information.