If you're not familiar with the term direct indexing, you're not alone. This article will educate you on the concept and explore reasons why direct indexing may be the next frontier for index investors.
Index investing: a craze
If you're already a fan of index investing, you're probably familiar with John Bogle, the founder of Vanguard and the father of index investing. Vanguard created the first index fund, allowing investors to access broader markets through passive management at a low cost without having to pay a manager fee.
At a swift pace, clients are moving toward passive index investing. In fact, in a 2024 CNBC article, Morningstar cites that there's currently $13.29 trillion dollars in passively managed funds.
Index investing is popular and is often believed to clash with the professional wealth management industry. However, advisors who have already embraced index investing could be well-positioned to usher in the next era for their clients, leveraging the possible benefits of low-cost passive management and broad market exposure, along with the additional features offered by direct indexing, which we will discuss further.
Taxes and index investing
Despite the numerous potential benefits of index investing, traditional index strategies don't always optimize after-tax returns. From a tax perspective, enhancements may be made to traditional index investing, allowing investors to be more dynamic and nimble inside their passive strategy.
For example, when investing in an index like the S&P 500, you are buying a basket of securities that simply tracks the S&P 500. The possible advantage lies in harnessing the performance of individual components that make up the S&P 500. A benefit emerges when we analyze the performance of these individual components. Let's take 2024 as an example: the S&P 500 index was up 23% by year-end, but that isn't the full story for all names inside of the index, let alone the names throughout the year. This graph shows how many stocks inside the S&P 500 were down more than 5% at some point in the year (in green) and by year-end (in grey).
Even by year-end, with the S&P 500 finishing the year up 23%, over 100 names of the 500 companies were down more than 5%. In fact, in 2024 over 300 of the S&P 500 stocks had an intra-year decline of 5% or more. This could be seen as a potential tax-loss harvesting opportunity. Remarkable, isn’t it?
What is tax-loss harvesting?
Tax-loss harvesting occurs when you make an investment, but the investment at some points is in a loss position (negative). Tax-loss harvesting is a strategy where you realize a loss, also known as selling an investment while it’s down, and using that realized loss to offset other realized gains in your portfolio.
Direct indexing
Direct indexing allows us to replicate or buy a basket of names that resemble the S&P 500 at the company level. This is done through a separately managed account (SMA), meaning you own the names directly rather than indirectly like you would through an index fund, ETF or mutual fund. So, when a client reviews their statement, instead of seeing just the S&P 500 ETF, they would see the individual names of the companies that make up the S&P 500, along with the number of shares they own in each company. Because you know these names are owned on an individual basis, we can take advantage of intra-year price fluctuations and tax-loss harvest inside the index
So back to the S&P 500 example. Let's go back in time and say an investment was made on January 5, 2024, and an S&P 500 index fund ETF is purchased. In this example, there really wasn’t a time that index as a whole went down the rest of the year. That's wonderful from a returns standpoint but recall the previously mentioned graph that showed inside the S&P 500; there were names that were negative. So, investors who owned the S&P 500 in a direct index strategy may have done better on an after-tax performance basis by simply harvesting losses in those negative stocks throughout the year with intra-year fluctuations.
Additional direct indexing strategies and benefits
Now, let’s cover a couple of other strategies with additional possible benefits. Instead of looking purely for better after-tax performance, a client might wish to harvest only losses. A client might use a strategy like this if they have capital gains elsewhere in their portfolio or expected capital gains they’d like to offset. Again, if the client just owned the S&P 500 ETF, they may not have the same level of losses to harvest if the index as a whole is positive.
Direct indexing concepts can also be used in tandem with charitable giving. You might be used to the idea of gifting appreciated securities to charities rather than giving cash. If not, please contact us. Going back to our 2024 S&P 500 example again, if you owned the S&P 500 ETF, you could donate that ETF and shield the 23% gain from taxes by gifting that ETF to charity directly. However, if you owned names in the S&P 500 directly as we explained above, you can gift the securities on an individual basis. Let’s select a no brainer example: Palantir was up 340%. Would you rather shield 23% of gains from taxes or 340% gains? It’s an example of the potential power of combining direct indexing with your charitable giving.
To share one final use case, even though there are possibly many more. For clients that may have certain industries they’d like to steer clear of, or companies they want to avoid, direct indexing is an option. This would be considered environmental and social governance (ESG) investing. The good news is that in these cases, you can apply a filter to the broader index and say "exclude XYZ company or avoid investing in XYZ industries." Direct indexing strategies such as this allow clients to have a hand in creating a bespoke portfolio.
How does direct indexing stack up in terms of cost?
You might be thinking this all sounds great, but how much does this strategy cost compared to an ETF that is passively managed, where internal costs are minimal? The great news is technology is making things more accessible and less expensive. In some cases, advisors can offer direct indexing to clients for a very similar cost as ETFs due to technology doing the day-to-day trading.]
Potential drawbacks of direct indexing
Direct indexing may shine brightest in taxable accounts due to its tax-loss harvesting capabilities. However, this advantage diminishes in tax-advantaged accounts like IRAs or 401(k)s, where gains are already tax-deferred. Consequently, the strategies that make direct indexing attractive, such as tax-loss harvesting, may be less beneficial in these tax-advantaged environments.
One may also consider potential accessibility issues when considering direct indexing. This strategy has traditionally been a strategy favored by wealthier investors due to the high minimum investment requirements. Although advancements in technology are gradually lowering these barriers, making direct indexing more accessible, it may remain beyond the reach of some investors.
Benefits of financial planning when it comes to investments
People hire financial planners for many different reasons, and many are not looking for an actively managed investment portfolio, which is totally fine. Remember that clients find value in different places and ways when working with us as their financial planners. Managing through significant tax years, talking clients off a ledge during uncertain investment times or even setting the right asset allocation for a client by using passive equity investments while reducing the total cost to them by skipping active managers. Those are just a few reasons why clients feel like they are getting value for the fees they are paying, even when they are paying by the more traditional model of assets under management (AUM).
Conclusion
There's a notion that investment advisors and financial planners prefer active management, which is not always the case. We routinely deploy and utilize passive management for any number of reasons like we expressed above. Direct index strategies have all the appeal of traditional low-cost ETF indexing with some added charisma, so of course advisors may use them for clients when it makes sense and is the right thing to do.
One word of caution: just because it's called an index fund doesn't mean it's a good investment. And just because it's called an index fund doesn't mean it's the right investment for you. Remember, an index fund is simply an investment that tracks a broader industry or market. For example, investing in an S&P 500 index fund would be vastly different than, say, the SPDR S&P Kensho New Economy index fund. They both have the letters S&P and index fund in the name, but they'd be incredibly different investments.
In conclusion, some consider direct indexing to be the next era of indexing, which has historically been done in mutual funds and ETFs. It may offer a powerful way to enhance traditional index investing by providing opportunities for tax-loss harvesting, personalized investment strategies and potentially better after-tax returns. This innovative approach allows investors to replicate the performance of major indices like the S&P 500 while owning individual stocks directly, enabling more precise management of gains and losses. However, this strategy may not be a good choice for use in tax-advantaged accounts, like an IRA. It also has higher minimum investment requirements, making it less accessible to some investors.
Direct Indexing is not just about mimicking the market; it's about optimizing the investment strategy to align with your financial goals and values. Whether you're looking to minimize taxes, maximize charitable giving or adhere to ESG principles, direct indexing may help provide the flexibility to tailor your portfolio to your unique needs.
In some cases, advancements in technology have made direct indexing more accessible and cost-effective, getting the costs closer to traditional low-cost ETFs. This means you may enjoy the benefits of personalized investment management without the high costs typically associated with active management.
As financial planners, we see the value of both passive and active management. For some clients, direct indexing bridges the gap between these two approaches, offering a dynamic and efficient way to invest. It's an exciting development in the world of index investing, and financial planners can help clients navigate this new frontier.
So, whether you're an index investing enthusiast or new to the concept, direct indexing may be worth considering. Direct indexing can be a helpful tool for tax-conscious investors with larger portfolios who are looking for customization and control. However, the higher costs, increased complexity, and potential for diminishing tax benefits make it essential to carefully evaluate whether it aligns with your specific investment goals and circumstances.
Let's embrace the future of investing together and explore how direct indexing could help you achieve your financial goals.
This information does not constitute investment advice and is not an offer to buy or sell a security. The material is provided for general information and educational purposes and is based on information provided to us by sources deemed to be reliable. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Past performance is no guarantee of future results and asset values will fluctuate with changing market conditions. There is no guarantee that the views and opinions expressed in this document will come to pass. Investing in the market involves gains and losses and may not be suitable for all investors. All investments are uninsured and can lose value. AI (artificial intelligence) was utilized to assist in the creation of this marketing piece.
Baker Tilly Wealth Management, LLC (BTWM) is a registered investment advisor. Reference to registration does not imply any particular level of skill. BTWM does not provide tax or legal advice. BTWM is not an attorney. Estate planning can involve a complex web of tax rules and regulations. Consider consulting a tax or legal professional about your particular circumstances before implementing any tax or legal strategy. The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought.
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