Direct Indexing: Using Automation to Improve After-Tax Returns

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The investing world has become more accessible than ever in the past decade.

The examples are many: the rise of new trading apps built for mobile use (Robinhood and others). Slices of stock available to purchase with as little as a few dollars. Transaction-free stock trades. Private investments available to purchase that previously were reserved for the ultra-wealthy.

It can feel overwhelming. You need a discerning eye to comb through the available products, services, and funds to find the match for your needs.

At Andrews Advisory Associates, LLC, we have an investment committee that meets regularly throughout the year. It’s comprised of me, Christina, Scott, and most recently, Owen. The idea is that we apply our individual experiences to refine our collective firm-wide investment philosophy. During this process we’ll share ideas about funds, strategies, and products that draw our attention and lead to deeper investigation and potential use in our portfolio.

One of the strategies we’ve implemented is Direct Indexing. It’s proven to be a useful tool for investors in situations where tax planning in brokerage accounts is critical.

In today’s post, you’ll learn:

• How Direct Indexing works in real-life situations.

• How it combines index-like investment characteristics with improved after-tax investment returns.

• The drawbacks of Direct Indexing to know before investing.

How Direct Indexing Works

Direct Indexing (DI for the author’s sake) is an investment strategy that allows you to purchase the individual stocks of an index directly. This is an alternative to purchasing an ETF or mutual fund which tracks an index. Direct Indexing allows the investor to own actual shares of the stocks.

Before major custodians switched to commission-free stock trades, it was impractical for most except the very wealthy to use Direct Indexing. Now that most stock trades fees have gone away, the accessibility of the strategy has gone way up.

Here’s how it works:

1. The investor identifies what Direct Indexing provider they will use. The service is provided by well-known custodians (Charles Schwab, Vanguard, Fidelity) and custom portfolio specialists like Parametric.

2. The investor chooses the benchmark whose performance they are seeking to track.

3. The DI provider buys the individual stock positions. This can be hundreds (sometimes thousands) of holdings to mirror the index. Most providers use sampling to match the index as closely as possible.

4. Once the stocks are purchased, the DI platform looks for opportunities to harvest tax losses among the hundreds of stock positions. When a position is sold, the proceeds are used to purchase another closely-related substitute immediately, minimizing tracking error.

5. Automated rebalancing and tax-loss harvesting occurs.

6. The portfolio can be customized to fit the investor’s preferences with various tilts and stock filters.

   
   

The result is a system of index-based investing which lowers the burden on the investor to manually realize tax losses while providing diversification. The key is automation, which realizes tax losses without the user deciding what and when to sell.

Direct Indexing Benefits

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The two main benefits are:

1. Ongoing monitoring to capture realized losses as a part of broader tax strategy. In doing so, investors hope to improve after-tax returns.

2. Portfolio customization while seeking to minimize tracking error. Investors can still follow an indexing investment approach while making the slight adjustments their situation calls for.

   
   

DI technology constantly looks for opportunities to execute trades that minimize tracking error to the benchmark while banking losses to offset realized gains or up to $3,000 of ordinary income each year.

This can be useful for investors with concentrated stock positions who prefer avoiding large capital gains tax bills.

Through Direct Indexing in their taxable accounts, they can accumulate realized losses to offset realized gains from paring down their concentrated stock position. You could certainly do this manually by buying stocks yourself to track an index, but it takes time and effort to keep track of cost basis and remember to do trades throughout the year. The automated tax loss harvesting can be a part of a multi-year plan to reduce concentration in one stock position.

Another advantage of Direct Indexing is the customization of portfolio holdings.

You can track domestic and international stock indexes and even add tilts and screens to filter certain industries out. I’ve used this feature for clients with concentrated stock positions to exclude that company from the Direct Indexing portfolio to avoid adding more exposure.  Some investors also use the customization feature to build socially responsible ESG portfolios.

Now onto the drawbacks to be aware of…

Direct Indexing Drawbacks

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There are some things to know before jumping into Direct Indexing.

1.      Fees

Companies charge a fee for implementing Direct Indexing, usually between 0.15% - 0.50% of the assets in the DI strategy. The more customization required, the higher the fees usually go. If you work with a financial advisor, this fee may be in addition to their advisory fee.

Compared to the very low expense ratio of some ETFs, Direct Indexing is more costly. The tax benefits should exceed the fee difference to make DI worthwhile. This is usually true for investors in a high tax bracket or with concentrated stock holdings – but check with your CPA and advisor first.

2.      More individual holdings = longer monthly statements

This is something that catches people by surprise.

Instead of owning a handful of mutual funds/ETFs, you own hundreds or thousands of individual stocks with Direct Indexing.

That means your monthly statements might go from a few pages to dozens of pages – just because the number of holdings goes way up.

If you get your statements mailed to you, keep in mind that they’ll be a lot thicker than before.

There are some providers that offer a hybrid approach, purchasing sector ETFs instead of individual stocks, which dramatically reduces the number of holdings required in the portfolio.

3.      More trade confirmations

Related to #2 – trades are going to be done with more frequency than before. That means the number of trade confirmations you receive will go way up.

If you get trade confirms emailed to you – you might find your inbox flooded.

One potential solution to this is creating a separate email address for your Direct Indexing emails. Trade confirmations and monthly statements get sent there and won’t take up space in your main email.

4.      Coordination required to avoid wash sale complications

The wash sale rule [Capital Gains and Losses: How to Strategically Lower Your Tax Bill] can affect your Direct Indexing strategy in a bad way.

Since the rule applies to purchases made across all your accounts, including IRAs, some coordination is required. You need careful planning to avoid a trade in your IRA disallowing realized losses in the DI account.

5.      Minimum account sizes enforced

This strategy works better with larger account sizes. Due to the large number of stocks being purchased, there needs to be enough cash available to execute all buys. Many providers have a minimum required account size of $100k - $200k to start.

In Summary

Direct Indexing can be a powerful tool for investors in high tax brackets. It can allow for a more tax-efficient, automated trading approach. It’s not without its downsides – the increase in complexity from the additional holdings usually catches people by surprise in the beginning.

Consult with your advisor about whether Direct Indexing has a place in your investment portfolio.

That’s all for now – have a great weekend.

 

Travis

Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor.  This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.