Direct Indexing for the DIY Investor
Direct indexing has been around for a couple decades, but is now more accessible to the individual investor. Technology, fractional shares, and feeless trading of equities all contribute to bring direct indexing into the present. In fact, even Vanguard recently announced they will offer direct indexing (through their advisors).
What is direct indexing for the DIY investor, and why did Vanguard start offering direct indexing? What are the pros and the cons, and, ultimately, what is the most important consideration (that is heretofore overlooked)?
Direct Indexing for the DIY Investor
In the olden days, the wealthy invested in SMAs (separately managed accounts). SMAs are complex, pricy due to trading costs (and advisor’s fees), and had to be quite large (as there were no fractional shares).
The advantage of an SMA over index funds are the ability to tax loss harvest individual positions. Actually, initially it was to beat the market, but we all know how likely that is in reality. Evidence shows that SMAs do not beat the market, and the idea that you can get an “alpha” from stock picking fell out of favor.
Still, there are reasons one might want to own individual stocks rather than broad-based, inexpensive ETFs.
To be clear, index-based ETFs are the gold standard in investing. They are inexpensive, diverse, and very tax-efficient.
In order to beat a portfolio of 2-6 ETFs in a brokerage (taxable) account, direct indexing must be pretty special. We will talk about Pros and Cons of direct indexing below, but first, what is direct indexing?
What is Direct Indexing
Say you want exposure to the S&P500. Instead of buying an ETF, you could own just 80-150 stocks in the index that represent the whole.
The idea is that if you buy representative stocks from an index, you can get the same returns, and that the “tracking error” (the difference between the index and your direct index) is minimal.
These days, direct indexing can be extraordinarily inexpensive, and tax efficient, and will be available to non-advised (DIY) investors.
The tax efficiency comes from tax loss harvesting. When one of your stocks is down, you can sell it an buy a similar stock from the index that will have the same tracking error. This allows you to recognize the loss that year on your taxes, and re-sets the basis lower in the new position. Note that if you sell that position in the future, you will pay those deferred capital gains; but tax paid tomorrow is usually better than tax paid today!
Also, say you want a ESG portfolio, or a portfolio with a value or momentum or other tilt. It is easy to pull some levers when you set up your account, and just select the equities that meet your criteria.
There are many Pros to direct indexing. Let’s look at them now
The Pros of Direct Indexing
You can exclude gun manufacturers, pharmaceuticals, dirty energy, or any other evil corporations you wish
You can select for momentum, growth, value, quality or any tilt you wish
Diversify from your profession-
Say you work in an industry that is cyclical and might go down the same time you lose your job; you can exclude your company (or even your industry) in your direct index
Diversify a concentrated position-
Moreover, if you have gains from stock options or equity reimbursement, you can diversify away from that position. If these positions have low basis, you can recognize other losses and sell your gains over time to minimize current capital gains tax
Diversify from old, tax-inefficient mutual funds-
If you have large gains in old fashioned, expensive, tax-inefficient mutual funds, you can get rid of those over time without recognizing the gains, and essentially buy back the individual holdings of that fund, if you like
High taxes now-
If you are in the 23.8% capital gains tax bracket now, but likely will have access to the zero or 15% bracket later, you might defer your capital gains with direct indexing
Moving to a low tax State in retirement-
Similarly, if you are moving away from a high tax state, paying your taxes later may make sense
The Cons of Direct Indexing
There are, of course, important cons to direct indexing that need discussed.
Defers the gains-
Understand that tax loss harvesting just defers the gains. This is great if you get a step up in basis at your death or want to give them away to charity, but eventually someone will pay the taxes
Complexity in Statements-
An ETF may have a page of gains and losses, whereas you will kill multiple trees printing out your statements from a direct indexing account. All of the positions, all of the lots, while it is easy for technology, it is not easy for a mere human to sift through
Complexity in Taxes-
…let alone your tax professional. Give them the 280-page 1040 from your brokerage account and see the look on their face
Becoming Locked In-
Eventually, after about 10 years, you will have nothing but gains in your account and thus will no longer be able to tax loss harvest. At that point, you have 80-200 individual positions you need to manage instead of 2-6 ETFs.
Complexity when Locked In-
And this complexity is a massive downside. It leads me to the point I don’t hear people considering as the main downside of direct indexing
The Main Disadvantage to Direct Indexing
As to my main issue with direct indexing: where will you be in 10 years?
As I mentioned above, the market (and thus the individual equities that make up the market) increases over time. Eventually you will be locked into your portfolio. By “locked-in,” I mean that you will have painful, large embedded capital gains that you need to recognize if you with to use the money prior to dying and getting a step up in basis.
Instead of having 2-6 ETF positions, you might have 150 individual equity positions. That’s a lot of decisions that need to made and a lot of complexity for the older you!
What will you be doing in 10 years? What is your need for income? How to treat the multitude of individual positions? Will that company go bankrupt?
The idea with a broad market ETF, is that you buy it when you have the money and you sell it when you need the money. Then, you leave it behind for your heirs to get the step up in basis. In that setting, the deferred capital gains you have are great: no one ever pays the taxes on them!
But if you have 120 individual positions, you will need to decide individually which ones you are going to sell when you need the money, and which you leave behind when you die.
What if you don’t die for another 30 years? Are those individual companies still going to be around in 30 years? We know the total market ETF will be there and will be valuable, as it has a self-cleaning mechanism.
True, individual stocks in an index ETF do go to zero and you lose the value when they do. But since these ETFs are Cap Weighted, you have less and less to lose as their price goes down. “You” sell when they decline in value, and buy those stocks that replace them and increase in value.
When you own the individual equity outright, you ride it all the way to zero without getting out along the way.
In summary, consider where you will be in 10 years with your direct index.
What will you do with the 100’s of individual equities rather than the 2-6 ETFs over time? Will you be more likely to need someone to manage your account (and thus have the additional expense in the future)? Will you be willing to trim your losers knowing the psychological headwinds of doing so? Can you let your winners ride to be inherited or given away at low basis?
Summary: Direct Indexing for the DIY Investor
So, in summary, if you have an indication for direct indexing (large capital gains you want to mitigate, or you currently live in a high tax state but are moving and retiring to a lower tax bracket—this is tax bracket arbitrage), you might consider direct indexing as a DIY investor.
But certainly, consider the downside! After about 10 years, you will be locked-in to the gains, and you will have hundreds of individual positions to consider. Who will die first—you, or an individual stock?
Returns are not expected to be better with direct indexing than investing in ETFs. Can you get some tax alpha with direct indexing? Perhaps, but the cost is complexity when all is said and done.