What if you could track a broad market index while still customizing your portfolio to meet your unique financial goals? What if, in doing so, you could potentially save money on taxes, while taking into account your current holdings and any personal views you might want to express?
Due to its potential tax efficiencies, direct indexing can make sense for many investors, but in particular, here are three cases where you may want to explore direct indexing more closely:
- You have a concentrated holding in your portfolio.
- You want to make charitable contributions.
- You want your portfolio to reflect your social views.
What Is Direct Indexing?
Direct indexing involves investing in a market index such as the S&P 500 but doing so by purchasing individual securities rather than a mutual fund or exchange traded fund (ETF). In other words, rather than buying a basket of stocks collectively held with other investors, direct indexing allows you to personally own shares in individual companies. Ultimately, the goal is to track the performance of a segment of the market or a model portfolio, but because you own the individual securities, you have greater flexibility in how the portfolio is constructed.
The Case of the Concentrated Position
The first use case to focus on is an investor with a concentrated position. For instance, you might have purchased Apple stock in the early 2000s. If so, congratulations, your initial investment has multiplied many times over. This does, however, leave you with an (admittedly good) problem, because now Apple might make up a large portion of your total wealth. You could just sell the stock, but doing so would produce a huge tax bill (if it’s held outside of a retirement account). Furthermore, the stock has been good to you, so maybe you don’t want to sell it all.
The obvious first step here is that you probably don’t want to buy more Apple since doing so would exacerbate your concentration risk. But suppose you buy an S&P 500 ETF to round out your portfolio? Well, as of this writing, Apple makes up approximately 6% of the S&P 500. That means that even though you are purchasing an ETF, you’re actually increasing the exposure you have to Apple. Plus, other companies in the S&P might have high correlations with Apple. That means that when Apple zigs or zags, these companies do the same. Think of other companies in the technology sector or companies that supply components to the iPhone.
That’s where direct indexing can help. Using direct indexing, you’d still recreate the S&P 500 with the remainder of your portfolio, but you’d do it in a way that doesn’t double down on your existing exposure. For starters, you wouldn’t buy any more Apple. You’d also avoid or underweight companies that tend to closely track the performance of Apple.
The result? A more broadly diversified portfolio that still tracks the S&P 500 while reducing your concentrated exposure. And as a bonus, you could use some of the tax-loss harvesting capabilities direct indexing provides to accumulate losses you could use to offset the gains from whatever portion of the Apple stock you ultimately decide to sell.
More information here:
Financial Mistakes High-Income Professionals Should Avoid
Is It Just ‘Too Hard?’ Know Your Circle of Competence
The Case of the Charitably Inclined
Direct indexing can also make sense for individuals who have charitable goals. For instance, let’s say that someone has a portfolio worth $1 million, and they want to donate $25,000 each year to charity. Giving cash is great, but giving appreciated securities is even better. That means that if our hypothetical investor owned an S&P 500 ETF and its value increased over time, they could benefit from gifting shares of the ETF rather than cash. The reason for this is that if they sold the ETF to spend the money, they would owe taxes on the capital gains. But if they donated the shares, they would not only receive a tax deduction on the donation, but they’d also avoid paying capital gains taxes on the appreciated security.
Direct indexing can take this strategy and add rocket fuel to it. Even in an up year, the majority of stock market returns are driven by a small subset of winners, while a substantial number of stocks might decline. Now, consider the following scenario. You recreate the S&P by purchasing 100 of its underlying stocks. The overall basket gains 10%, driven largely by 30 “winners.” Thirty other stocks decline in value, while the remaining 40 stocks tread water or increase slightly.
Step #1
Own the S&P via individual stocks and achieve the 10% return of the index.
Step #2
Sell the “losers” via tax-loss harvesting, and replace them with comparable securities to maintain consistent market exposure while accumulating tax losses to offset any future gains.
Step #3
Donate the biggest “winners” to charity, thereby avoiding capital gains while also generating a tax write-off.
Step #4
Rebalance the portfolio to continue tracking the S&P 500, and then repeat the following year.
As you can see, this is a more customized approach to managing one’s finances than simply buying an ETF and then writing a check to your favorite charity. The strategy is the same, but the tactical implementation could result in significant tax savings over time, leaving a larger portfolio in the future and/or allowing for greater charitable contributions.
The Case of the Socially Engaged
When an investor has social or personal views they want to overlay on their investment portfolio, they might select from a wide range of mutual funds or ETFs that underweight or even avoid certain securities or sectors. The problem with that approach is that everyone is unique, and no two people share the exact same social viewpoints. It can be hard to find a fund that precisely reflects what you are trying to add to or avoid, while still generating attractive returns (this is investing after all, and the goal is to make money).
That is where direct indexing can help. Once again, you begin by identifying an index or market and recreating it. Then, you overlay your social views on the portfolio by restricting certain stocks or sectors from purchase. The key is that this is your own customized portfolio, and you are purchasing individual stocks. That means that you have complete control over what does or does not go in the portfolio. The finished product will reflect you and your views.
You will, of course, want to keep in mind that your investment goal is to recreate and track an index. The more restrictions you put on what can be bought, the more difficult it will be to track that index. For instance, if you restrict the purchase of a small company that has a 0.5% weight in the S&P 500, you still can build a portfolio that closely tracks the S&P. On the other hand, if you wanted to restrict the purchase of all companies in the technology sector, well, you can do that if it reflects your personal beliefs. But since technology makes up approximately one-third of the S&P 500, the finished product’s returns and volatility will deviate meaningfully from that of the underlying index. I’d still consider this direct indexing, even if it is a little extreme, but you would have a much higher tracking error.
The Downside
While direct indexing has many benefits, there are downsides as well—many of which come from the increase in the number of positions you’ll hold. When you go from holding a single index fund to perhaps several hundred individual stocks, you are adding complexity to the mix. For starters, you’re going to see more line items and trade confirmations, which can make tracking your portfolio more cumbersome.
The increase in holdings also means that if you decide down the road that you no longer want to direct index, you’ll need to figure out what to do with all of the individual stock positions. Do you keep them? Do you sell them?
Direct indexing would also be a time-consuming approach if you chose to implement it yourself. That time commitment can be offset if you use a professional manager to implement it. If you go that route, make sure to shop around for the best one for your circumstances. But if you use a professional manager, the tradeoff is cost. The cost for many direct indexes is reasonable, and you should have no trouble finding one that costs less than 0.50% per year. But that is still more expensive than an index fund or ETF, so you need to make sure the extra benefit you are getting outweighs the cost.
More information here:
How to Build an Investment Portfolio for Long-Term Success
The Bottom Line
The bottom line is that while direct indexing allows for significant customization, you’ll want to strike a balance between personalizing your portfolio while still achieving the returns of the index you are seeking to replicate at a reasonable cost and without unnecessary complexity. Nevertheless, if you have a concentrated position, if you have charitable goals, or if you want your investing to reflect your social views, a personalized portfolio built through direct indexing might be the right approach for you.
[FOUNDER'S NOTE BY DR. JIM DAHLE: Direct indexing (DIing) can be worthwhile for the right person. The main point of DIing is to maximize your capital losses. The person for whom it is right will generally have a very good use for those losses, like selling a highly appreciated business down the road. Most WCIers investing a significant amount of money in taxable accounts can get more losses than they can ever really use just with occasional tax-loss harvesting (like once every few years) at the fund level. No need for DIing. When you add on concerns about cost (although DIing is available for as little as 9 basis points), the difficulty tracking the index, and the complexity involved should you ever decide you don't want to do it anymore, DIing is far from a no-brainer.
In this article, the author explores three other reasons one might want to explore DIing. However, the article doesn't really mention that there are other ways to get similar benefits. For example, if you have an appreciated stock, you can use it for your charitable donations, you can buy puts against it, you can sell it short, or you can exchange it for shares of a more diversified exchange fund (351 exchange). Combining tax-loss harvesting with the donation of appreciated shares to charity is something Katie and I have done for a long time. It's a powerful technique. But we'd never take on the risk, cost, and complexity of DIing JUST for that purpose. The more charitable you are, the less likely you are to benefit from the additional value you could potentially get from successfully implementing the outlined strategy.
And I've written many times about how silly it is to invest in a “socially engaged” way. After the Initial Public Offering (IPO), buying and selling shares of a stock don't affect the company in any significant way. Certainly you choosing not to invest in a gun or alcohol or gambling company doesn't somehow mean there will be fewer shootings or less drinking or less gambling in the world. There's no connection whatsoever, despite the hopes of naive investors. Might as well keep your investing life simple and donate the extra earnings of an intelligent, low-cost strategy to a nonprofit actually working on the problems you care about.
But if you have a good use for the losses you get from DIing, know you'll stick with it for the rest of your life, pay a very low price for it, and ALSO highly value one or more of the three benefits discussed in this post, then wonderful!]
What do you think? Have you tried direct indexing? Was the complexity and potential extra cost worth it for you?