By Dr. James M. Dahle, WCI Founder
While not every last person is convinced, the majority of informed investors and advisors in the personal finance/investing world are now very much aware of the benefits of index fund investing. These include:
- Guaranteed market-matching returns
- No manager risk
- Low costs
- Long-term outperformance of majority of active managers
- Easy portfolio construction
- Minimal hassle
It might have taken decades, but Jack Bogle's “cost matters” hypothesis has finally reached widespread acceptance. However, that is not to say that index funds are without any problems whatsoever. In an attempt to overcome those problems and provide even more benefits than index fund investing can, some people have taken to an approach called “direct indexing.” But is that something you should be thinking about?
What Is Direct Indexing?
Direct indexing is simply buying all of the stocks yourself instead of paying a mutual fund to do it for you. Your goal is still to match the market, not beat it, but you're cutting out the middle man, i.e., the mutual fund manager. You own the stocks directly instead of indirectly.
What's the Problem with Just Using an Index Fund?
What's the point of doing that, you may ask? Well, that's where we come down to the (admittedly very minor) issues with index fund investing. Let's go through them.
#1 Mutual Funds Don't Pass Through Tax Losses
Here's the biggest one. When a stock has a big loss in a mutual fund and is then sold, that loss can only be used to offset gains inside the fund. All the losses are added up and subtracted from the gains, and then the remainder of the gains are passed on to the investors. Some broadly diversified index funds, particularly those with a corresponding ETF share at Vanguard, have mastered this game so well that they have not had a capital gains distribution to investors in literally decades. That's a wonderful benefit of index funds. But what they do not do is distribute to you any additional losses to put up against gains in other investments or against your ordinary income (up to $3,000 per year).
If you want to do that, you will need to “direct index,” jettisoning the mutual fund shell and its regulations. Mutual funds can be tax-loss harvested like any other investment. But you are simply going to have more losses by owning hundreds or thousands of stocks individually than you will by owning one fund that sums those losses and gains together before distributing anything—and that is not permitted to distribute capital losses.
#2 Mutual Funds Have Expenses
Index funds have some expenses. Other than Fidelity's “Zero” index funds, mutual funds have an expense ratio that is paid every year. Granted, this is not a very large number for the best index funds, almost always less than 20 basis points a year, but that can add up with a really large portfolio. Remember, 0.10% of $100 million is still $100,000 a year, and you can do a lot with $100,000 a year.
#3 Mutual Funds Offer Less Control and Autonomy
Mutual funds have a manager who manages the fund. You don't get to manage it. So by definition, you are going to have less control and autonomy over the portfolio. You don't get to decide when to harvest a loss or which stocks to use to match the index or when to add or remove a stock. You also do not get to control the exact tilt if you choose to tilt your portfolio toward or away from some sector of the overall market. You can use different mutual funds to achieve commonly desired tilts, of course, but this isn't the same thing. With direct indexing, this control is yours without any additional mutual funds. A common tilt available through direct index providers is an ESG (Environment, Social, Governance) tilt, with its pluses and minuses.
#4 Tracking and Manager Error
Some index funds struggle with tracking error. They don't actually match up very well to the index they are supposed to be tracking. In order to keep costs down, they generally sample an index, and if they do a poor job sampling and rebalancing, they may lag their index significantly. I find this a weak argument to make against the well-known, established index funds like those at Vanguard, Fidelity, Schwab, and iShares, but it can certainly be made against some poorly run index funds.
#5 You Don't Get Invited to Shareholder Meetings
You also do not get invited to shareholder meetings of the individual companies when you own them through a mutual fund. In fact, there is a good chance that your mutual fund does not even vote your shares at the meetings.
Problems with Direct Indexing
It's not like direct indexing is some magical solution, though. If it were, we would have all been doing it long ago. The reason it has become somewhat more popular recently is that some changes have been made in the industry that decrease its downsides, which are hardly insignificant. Basically, some startup companies figured out how to automate many of the processes, and these companies were recently snapped up by the Wall Street giants. That's why you're now hearing about this idea.
One benefit of a mutual fund is that it provides economies of scales. Thousands or even millions of investors are banding together, and the costs of running the fund are spread out over all of those investors. Just like getting cheaper prices at Costco when you buy more of something, thanks to their volume of business, a big index fund can get lower costs than an individual investor can get. Imagine trying to replicate a total stock market index fund. There are 4,000 stocks in that index. Even if you only paid $6 per trade, a round trip through all of those stocks would be $48,000 in commissions alone. Seems like a non-starter for anyone but the super-wealthy making huge transactions, no? So what has changed? Well, there are now brokerages that do not charge commissions for stock trades. So making 8,000 trades is not necessarily cost-prohibitive anymore, even for the little guys.
I don't really enjoy managing a five- or 10-index fund portfolio. I cannot imagine managing a portfolio with thousands of individual stocks and bonds. I simply have better things to do with my time. However, thanks to the advent of computers and automated solutions, there are ways to direct index that are not as big of a hassle as it was before. Essentially, you're paying someone else to play mutual fund manager without having your investments legally be in a mutual fund. However, they still have to deal with illiquid stocks (the ones the index funds avoid by just sampling the index) and the fact that the stocks are going up or down while the thousands of stocks in the portfolio are being purchased.
#3 Fractional Shares
Unless you have a lot of money, you may find that you need to buy, hold, or sell 1/10 of a share or 1/2 of a share to match your index. Until recently, that was not very practical. However, there are now brokerages that offer fractional share investing which addresses this concern.
#4 Temptation to Lose the Main Benefit of Indexing
One “advantage” of direct indexing is you can leave out a company you don't like, such as Google or Facebook. However, that may or may not help your portfolio. Once you start making decisions like that, you're not running your own index fund. You're running your own actively managed fund.
Where Can You Get Direct Indexing?
You can obviously go open a brokerage account, write a computer program, use a spreadsheet, and direct index yourself. However, most people are not going to do this. They are going to hire someone else to do it for them. So, who can you hire? Well, in the olden days (just a few years ago), you hired an asset manager to literally buy and sell the various components of the index for you. These days, there is a more elegant solution, and it is being heavily marketed. It basically involves hiring an asset manager who, in turn, works with a big bank or investing company to use tools invented by the startup company that the big bank recently purchased for a billion dollars that does direct indexing for the asset manager. Yes, everybody I just mentioned wants to get paid, too. At any rate, let's look at some of the players.
#1 Morgan Stanley
Morgan Stanley bought Parametric, a pioneering company in the direct indexing/separate managed account space in late 2020. As the largest company in the space, Parametric has been doing direct indexing for wealthy clients since the early 90s, and it had more than $250 billion under management at the time of acquisition.
BlackRock bought the second-largest SMA company, Aperio, in early 2021. I could not find very much in the way of additional details.
#3 J.P. Morgan
Not to be outdone, J.P. Morgan bought OpenInvest in early summer 2021. OpenInvest has a heavy ESG focus in its SMAs. J.P. Morgan also bought another SMA firm that specializes in options, called SpiderRock Advisors.
In the summer of 2021, Vanguard bought the Just Invest company (its first acquisition ever) along with its direct indexing product, known as Kaleidoscope. It now offers this service primarily to advisors as a “value-add” that Vanguard can offer its clients. Basically, the advisor sells the client on the value of a separately managed account (SMA) doing direct indexing, then goes to Vanguard/Just Invest for the tools to actually do it. Note that you, as a DIY investor, cannot go to Vanguard and get this service. You must go through an advisor, presumably including Vanguard Advisor Services.
Fidelity partnered with Ethic way back in 2019 to offer ESG-focused SMA investing to clients. More and more advisors have been moving assets there over the last couple of years. If you are into British royal news, you may be aware that ex-royals Harry and Meghan partner with Ethic.
So where can you get direct indexing? By hiring an advisor that then works with one of these SMA companies.
What Does Direct Indexing Cost?
As near as I can tell, nobody is offering this directly to DIY investors. So, the cost is the cost of hiring a financial advisor—an asset manager to be precise. As investors have realized that managing a portfolio consisting of a handful of index funds is actually pretty simple, this is a way for financial advisors to continue to bring business into the door by offering something that the investor cannot (or at least probably does not want to) do.
Should You Do Direct Indexing?
I put direct indexing into the same category as DFA funds. I kind of like DFA funds. I also kind of like the idea of direct indexing. However, I seriously question whether either way is worth the cost of hiring an advisor that you would otherwise not hire. It's a pretty simple comparison, really. If the advisor is charging 1% a year, is the value to you of direct indexing worth more or less than 1% a year? Obviously, the less an advisor charges, the more likely that the value is there. If you have $100 million with the advisor, hopefully you're not paying anywhere near 1%. Maybe it's easier to find the value there.
Kind of like with Betterment and Wealthfront, these SMA companies have made a big deal out of tax-loss harvesting. It is a major selling point. But what is tax-loss harvesting really worth?
Well, you can put $3,000 a year of capital losses up against ordinary income. That's pretty handy. If your marginal tax rate is 33%, you just knocked $1,000 off your tax bill. But that's hardly worth paying 1% of a $1 million portfolio ($10,000 and growing) to get. Especially when you can likely score a few years' worth of $3,000 tax deductions pretty easily with just a couple of ETF transactions during the next bear market.
Otherwise, those losses can only be used against realized capital gains. You have to ask yourself whether your spending strategy is going to rely on realizing a lot of capital gains. If so, then maybe this is worth a little more to you. Naturally, tax-loss harvesting lowers the basis of anything that is harvested, but perhaps it allows you to sell a lot of stocks that did not get harvested without having to pay capital gains taxes. Then upon your death, your heirs benefit from the step-up in basis on all of those low basis shares.
Personally, I don't anticipate ever realizing very many capital gains from my portfolio. I already have more $3,000 annual losses than I can use during my lifetime, just from a transaction or two in the March 2020 CoronaBear. Besides, I am continually flushing capital gains out of my portfolio through charitable contributions. The income from our portfolio will likely be more than enough for us to spend in retirement. So, I would see very little value in additional tax losses in my personal life aside from the elephant in the room (a potential sale of WCI down the road at some point). Outside of that, it certainly seems like folly to hire an advisor just to get more tax losses.
Given that most white coat investors are not looking at the sale of a big company down the road, I suspect they would not benefit from additional tax losses above and beyond what they can easily and conveniently pick up in bear markets along their financial pathway throughout life.
Now if you ARE going to hire an asset manager anyway and they are not going to charge you any extra to offer direct indexing to you, then sure, take a look at it, especially if you have a big interest in the ESG tilt that most of these companies offer. Personally, I would not expect a direct-indexing strategy to outperform a simple index fund strategy on a pre-tax basis. Whether it outperforms after-tax and after management fees is highly dependent on your tax situation and the use of an advisor. For most of this audience, I think that is unlikely.
The investor should also consider the possibility of leaving this asset manager in the future. Owning thousands of individual shares is a pretty big obstacle to most of us taking over our own portfolio management. It would take weeks for an individual investor to liquidate that portfolio, and the tax consequences of doing so would be significant. You're basically committing to this strategy for the rest of your life. I need to see a lot bigger benefit before I can recommend that to most white coat investors.
What do you think? Do you direct index? Why or why not? If so, what firm and advisor do you use? What has your experience been like? Comment below!