Direct Indexing Strategies

Technology has changed the way we do many things and investing is no exception. A recent advancement with implications for our clients is called direct indexing. We believe there are a couple really good uses for direct indexing that we’re excited to be able to offer to our clients, but before getting into those cases, let’s back up and cover what exactly direct indexing is.

What is Direct Indexing?

Indexing is fairly well-known; it is investing in a fund (usually an ETF or mutual fund) that seeks to replicate the performance of an underlying index such as the S&P500 for large US stocks or MSCI EAFE for developed international stocks. The strategy is popular since it is straight-forward as to what the returns will be, it will be whatever the underlying index return is minus the expense of the fund used and usually a very small tracking error (depending largely upon how often the underlying holdings of the index were changed).

Direct indexing is just what it sounds like, instead of seeking to replicate the performance of the underlying index through an ETF or mutual fund, the holdings that constitute the index are purchased directly. For example, if replicating the S&P500 index, you would own all 500 stocks in the index. This idea has been around for many years, but it is technology advancements and industry changes (such as the cost of trading) that brings this to many investors instead of just the ultra-wealthy. Although we do believe it is a good thing for direct indexing to be widely available, there are some considerations to be aware of that we’ll discuss later on, but first, let’s look at what we believe the potential is.

Why Direct Index?

Direct indexing allows for unique personalization. The first way to personalize is with advanced tax control and the second way is for client’s who desire investment control (usually to exclude certain types of companies from their portfolios). There are some who wish to utilize direct indexing in order to save on investment costs by not having to pay the expenses for the ETF or mutual fund. We do not think that reason for direct indexing is appealing and we continue to utilize Dimensional Funds.

Advanced tax control covers several different strategies. The first is called tax-loss harvesting. When direct indexing, you have the control to sell individual holdings that are at a loss at any point. One of the most popular uses for this is a business owner who knows he will sell their business soon and incur large capital gains. With a tax-loss harvesting strategy, it could be set up to avoid selling any of the holdings at a gain while taking as many losses as possible. Those losses can be built up and carried forward until the business sells when the losses would help offset some of the gain. The uniqueness of doing this in the direct indexing strategy is that each individual holding can be sold if at a loss whereas if using a traditional indexing approach, a loss could only be realized if the entire fund were at a loss (all the holdings combining to a loss). The entire fund being at a loss is less common than holdings within the index being at a loss so there is a lot more potential to gather losses through direct indexing. There are two issues to be aware of when utilizing this strategy. The first is to avoid wash sale rules (again, technology has made this easier) and the second is to be aware that your returns will have “drift” from the underlying index. The drift occurs because you would no longer own the exact underlying holdings since you sold one (or several) of them to realize the tax loss. Another holding would be purchased in its place (and with similar risk characteristics), but you will now differ from the index. We’ll cover this point again later on.

The other way to control taxes includes a tax-loss component (though likely not as aggressively to lessen the drift from the underlying index) but adds control of the gains as well. Consider a charitably inclined individual, that person can gift the holdings that have large gains to charity and thus keep the overall capital gains of their portfolio lower. You can read more about this in our charitable gift section of the website. Another scenario around handling the holdings with gains occurs when making portfolio withdrawals. If using a standard index fund and you were to sell, there is no flexibility, the gain or loss is whatever the fund has done relative to your purchase cost. With direct indexing, when taking a withdrawal you can determine exactly how much capital gain to take (within the boundaries of what has occurred within the actual holdings, of course). Perhaps you are in a low tax year, you could sell the winners. In a high tax year? Raise the cash with positions at a loss or very small gains. There is much more tax flexibility with direct indexing.

Investment control is another way to personalize the direct indexing strategy. This is a newer concept, but one that is gaining in popularity as investors want to invest in companies that align with their values while avoiding those that don’t. You may have heard of the industry term for this type of investing, which goes by the acronym, ESG. The ‘E’ stands for environmental, which is how does the company’s actions impact nature. The ‘S’ stand for social, which includes how the company treats their customers, employees, and suppliers. The ‘G’ stands for governance, which will include things such as executive pay, internal controls and shareholder rights. When creating a direct indexing strategy, we currently have access to 21 different parameters of which you could choose any number to filter for. This is a level of customization that is completely unique to your preferences.

Practical Considerations

The personalization that direct indexing allows does not come without some issues to consider before implementing the strategy. There are a couple of considerations we will touch on, but both of these involve tracking error, so it is important to understand what that is before moving forward.

Tracking error is the measurement of the portfolio against the benchmark index, in terms of expected performance. Tracking error can be positive or negative (although the terms sounds like it can only be a bad thing). A low tracking error would mean that you are expected to perform very similarly to the underlying index and a high tracking error means that the performance might differ to a larger extent. For example, if you are trying to replicate the S&P500 index and you add some personalization and have a tracking error of 1% and the S&P500 returned 10%, you would expect to have a return in the 9-11% range. The tracking error occurs because you are personalizing the index and thus are deviating from the underlying holdings. This can help or hurt your return, that part is unknown, but the tracking error helps us understand how much difference we can expect to have.

One of the first decisions you will have to make is how much tracking error you are comfortable with. The answer usually will come down to what you are trying to accomplish. For example, if you have a large capital gain coming in a year or two, you will likely be comfortable with a larger tracking error, perhaps 20%, in order to fully utilize a tax loss strategy to help offset those coming gains. Another example would be customizing your strategy to exclude companies that sell alcohol. You would be able to see how much tracking error this would generate and decide if that is worth it for you personally.

Tracking error will also be a consideration when considering which index to replicate and how many holdings you wish to replicate with. If you are pursuing a direct indexing strategy with a relatively small amount of money, you will likely want to choose an index to track that has fewer holdings (for example, the S&P500 index of 500 holdings instead of the Russell 3000 that has 3000 holdings). The next decision is how many holdings to replicate the index with. The fewer holdings chosen the larger the tracking error will be. The reason to limit the holdings used to replicate is to avoid very small positions (as well as very lengthy account statements and tax forms).

When implementing a direct indexing strategy it will be important to fully understand these implications as you add your personalization to match your situation. It is a strategy with many potential advantages, but discretion needs to be used as you seek to incorporate the strategy into your portfolio and financial plan.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with your financial advisor prior to investing. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to effect some of the strategies. Investing involves risks including possible loss of principal. No strategy assures success or protects against loss. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investing in stock includes numerous specific risks including: the principal and potential illiquidity of the investment in a falling markets. ETFs trade like stocks, are subject to investment risk, fluctuate in markets value, and may trade at prices above or below the ET’s net asset value (NAV). Upon redemption, the value of the fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors. Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective. Socially Responsible Investing (SRI) / Environmental Social Governance (ESG) investing has certain risks based on the fact that the criteria excludes securities of certain issuers for non-financial reasons and, therefore, investors may forgo some market opportunities and the universe of investments available will be smaller. All examples are hypothetical and are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. Tax services are not offered by Private Advisor Group, Guillaume & Freckman, Inc., LPL Financial or affiliated advisors. We suggest that you discuss your specific situation with a qualified tax advisor.