Direct Indexing or VTSAX?
Direct indexing if you are the average DIY investor. The standard of care is VTSAX (or VTI), a 3-fund portfolio, or even 6-10 ETFs in your brokerage account with a smart tax-deferred pairing. When will direct indexing be better than VTSAX and forget it?
Instead of owning a total stock market ETF, consider owning just 80-150 stocks in the index representing the whole.
If you buy representative stocks from an index, you can get the same returns and minimize tracking error (the difference between the index and your direct indexing stocks).
Direct Indexing and DIY Investors
The tax efficiency with Direct Indexing comes from tax-loss harvesting individual positions. When one of your stocks is down, you can sell it and buy a similar stock from the index with the same tracking error. This allows you to recognize the loss on your taxes. but re-sets the basis lower (which means more tax liability in the future).
If you sell that position in the future, you pay deferred capital gains. Tax paid tomorrow is usually better than today! (The main exception in retirement planning is a series of partial Roth Conversions)
And direct indexing is the proper way to do ESG. Or a portfolio with a value or momentum tilt. Or some other tilt. Pull some levers when you set up your account and pick a subsample of equities that meet your criteria.
Some pros of Direct Indexing:
The Pros of Direct Indexing
ESG-
You can exclude gun manufacturers, pharmaceuticals, dirty energy, or any other evil corporations you wish
Tilts-
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 at the same time you lose your job; you can exclude your company (or even your industry) from your direct index
Diversify a concentrated position-
Moreover, if you have gains from stock options or equity reimbursement, you can diversify away from it. If these positions have low basis, recognize losses and sell 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 buy back the individual holdings of that fund
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.
Defers the gains-
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 kill trees printing 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
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, you will have only gains in your account and can’t tax loss harvest. You are locked into 80-200 individual positions you need to manage instead of 2-6 ETFs
Complexity when Locked In-
And this complexity is a massive downside. Eventually, you will be locked into your portfolio. By “locked-in,” you will have painful, significant embedded capital gains that you need to recognize if you wish to use the money before 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 be made and a lot of complexity for the older you! You can do it if go-go but not if no-go.
With a broad market ETF, 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. The deferred capital gains you have are significant, and you know the broad market will still be there even if you die 50 years from now.
But if you have a rainbow of individual positions, you must decide individually which ones you will sell when you need the money and which you will leave behind when you die. Are those individual companies still going to be around in 30-50 years?
When you own the individual equity outright, you ride it to zero without getting out along the way. If you are Cap Weighted, at least you sold it before it became worthless.
Summary: Direct Indexing for the DIY Investor
In summary, consider where you will be in 30-50 years if you use the awesome advantages of direct indexing. Is the upside worth becoming locked into the complexity of owning individual stocks instead of owning everything?
Or, 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 if you die what does your spouse do? Will you trim your losers, knowing the psychological headwinds ahead? Can you let your winner’s ride and be given away tax-free or inherited with a step up in basis?
If you have an indication for direct indexing, a DIY investor might consider it. Returns won’t be better with direct indexing vs. ETFs. The question that you need to answer: can you get some tax alpha with direct indexing?
Yes. But when all is said and done, the cost is complexity in your no-go years.
