Summary/TLDR
Direct indexing is a strategy of index investing that is more customizable and, if utilized by investors with certain characteristics, more tax-efficient than index investing through an index fund. The higher costs and account minimums associated with direct indexing, however, only make them a good fit for certain investors: usually high income earners, business owners, or high net worth investors. When the right investor uses a direct indexing strategy, they will likely find that their benefits far outweigh their costs. Work with a competent financial professional to determine if direct indexing is a good fit for you.
Direct indexing is a method of index investing with the objective of producing a higher after-tax rate of return on a specific stock index than an index fund (index funds will be explained below). There is a lot that differentiates direct indexing from index funds, and these differences make direct indexing appropriate for only specific types of investors. In this post, I will be discussing what these differences are, along with the following:
- What are capital gains/losses, and what are their implications?
- How does a direct indexing account differ from an index fund?
- How a direct indexing account can produce after-tax returns superior to those of an index fund
- When a direct indexing account is and isn’t a good solution
- Potential drawbacks of a direct indexing strategies
Before you can understand what a direct indexing account is and how it works, you first need to understand the taxable nature of capital gains and losses (if you already know how capital gains & losses work, click here).
Capital Gains & Capital Losses
In a taxable account, you will pay capital gains taxes on any profits made from the sale of stocks or bonds in that account. For the large majority of American taxpayers, this will be 15% (assuming the stock has been held for 12 months or longer). For example, if you bought a share of a company for $1,000 and it grew to $1,500 by the time you sold it, you would have to pay 15% in taxes on the $500 gain (also known as a capital gain) which comes out to $75. As a result, you will net $1,425 on this transaction. If, however, you bought a share of the company for $1,000 and it fell to $800 by the time you sold it, you would owe nothing in taxes. In fact, the $200 loss (also known as a capital loss) will actually help you owe less on your taxes in the following fashion:
- Capital losses are first used to offset future capital gains
Let’s say that you had a portfolio of two stocks, both purchased for $1,000. When you sell the two stocks, one has risen in value, to $1,500, and the other has fallen in value to $800. You therefore have a $500 gain on one stock, a $200 loss on the second, and a net capital gain of $300 on these transactions. Instead of paying 15% capital gains tax on the entire $500 gain, you were able to use your capital loss to offset some of it.
- Capital losses can then be used to (partially) offset ordinary income
Taking the above example again, let’s say that both stocks fell to $800 by the time you sold them, making your net capital gain -$400. Since you have no capital gains to offset, you can use this $400 capital loss to offset your ordinary income (up to an annual limit of $3,000 for a married couple filing jointly, or $1,500 for a single taxpayer). Any loss that still exists at this point may be rolled over to future years.
For the sake of space, this is a simplified example. The exact amount capital gains taxes owed could be marginally higher or lower depending on the taxpayers other sources of taxable income. My simplifying assumptions, however, don’t inhibit the mechanics of how capital gains and losses are incurred and interact with one another.
In short, capital losses can be used strategically to mitigate the cost of taxes in a portfolio. In fact, strategically incurring losses for this purpose even has a name: “tax loss harvesting”. And it is through utilizing this strategy that direct indexing accounts shine.
Direct Indexing Accounts vs Index Funds
An index fund is simply a fund (usually an exchange traded fund, or ETF) which tracks the performance of a stock index, such as the Dow Jones, the S&P 500, the NASDAQ 100, etc. Index funds are arguably the most cost efficient way to gain exposure to a diversified portfolio of stocks because a single fund could own thousands of individual companies. Furthermore, they are some of the cheapest funds out there, with net expense ratios usually ranging from 0.03%-0.10%%.
In a direct indexing account, you participate in the performance of a stock index through direct ownership of the stocks that make the index up instead of just owning a single fund. The S&P 500, for example, is a stock index composed of the 500 largest publicly traded companies in America. Through an S&P 500 direct indexing strategy, therefore, you would directly own stock in 500 (or at least most of the 500) companies that make up the index.
One final characteristic of direct indexing that differentiates them from ordinary index funds is their customizability. Many managers will allow investors to “customize” the makeup of their accounts for the purpose of slowly getting rid of a position with large capital gains over time and in a tax efficient manner. Some investors will use this feature of direct indexing accounts to exclude certain positions from the index for the purposes of values-based investing. While this is a nice feature of direct indexing accounts, it can also reduce the manager’s ability to track the performance of the index as closely as an index fund would.
Tax Advantages of Direct Indexing Accounts
Once per month, the managers of the direct indexing strategy will sift through the positions in the account and find the ones that are trading at a loss since they were purchased. They will then sell some of these securities and purchase shares of other companies in their place. If, for example, they see that shares of Pepsi are selling at a loss, then they might sell Pepsi and buy Coca-Cola, or vice versa. And since the index is made up of so many different companies, they can regularly find positions that are selling at a loss even though most of the index is likely appreciating. The end result is that the account value goes up over time (with performance very close to the underlying index), but individual constituents of the index have been sold at a loss along the way up. This strategy really shines during times of extreme market volatility, although most managers are able to produce very consistent results on an annual basis.
Compare this to the ownership of an index fund, however. Say you purchased $100,000 of an S&P 500 index fund, which then goes up by 30% over the next 3 years. When you look at your account statement, you would see that this original $100,000 position has grown to $130,000, but you have to account for the 15% capital gains tax that you will owe on this $30,000 in growth. So while you would see $130,000 on your statement, the actual amount that you would receive net of taxes from purchasing this fund is $125,500, which comes out to a 25.5% gain over those 3 years. If, however, you owned the index via a direct indexing account, most, if not all, of that gain would be “canceled out” by capital losses that would have been realized during those three years. For example, let’s say that the managers were able to realize $15,000 in capital losses which you use to offset the $30,000 in capital gains. Now, instead of netting $125,500, you would net $127,750, which is a gain of almost 28% over the 3 year period. This is ignoring the extra fees associated with direct indexing accounts, which will be discussed in a section below.
Also remember that you can use your realized capital losses to offset your ordinary income if you don’t have any capital gains in a given year. If you are in the 32% tax bracket, that would save you $960 per year in taxes. Certainly not life changing, but it’s better than nothing!
Drawbacks of Direct Indexing
The largest advantage that ordinary index accounts have over direct indexing is cost. Index funds are notoriously cheap, with expense ratios usually ranging from 0.03%-0.10%, depending on the fund family and the index being tracked. Direct indexing accounts, however, will usually cost around 0.35% annually, again depending on the manager and the index being tracked. Finally, direct indexing accounts will have investment minimums of usually no less than $100,000, making them totally inaccessible for some investors.
If you are someone who is a good fit for direct indexing (discussed below), however, the advantages of direct indexing usually far outweigh the costs. Research from Vanguard has concluded that direct indexing accounts could improve annual after-tax returns by up to 1.0% if utilized by the proper investors.
When Direct Indexing Accounts Are a Good Solution
Now that we’ve explored how direct indexing accounts work, let’s discuss who they are and are not appropriate for. The first characteristic of a good candidate for direct indexing is that they have a large amount of taxable investments (funds that aren’t in a retirement account like a 401(k) or IRA). There is no benefit to direct indexing in a retirement account (outside of the customizability of the index), because no capital gains or losses are realized on funds sold within those accounts. Direct indexing is, generally speaking, only a good solution if you have a large amount of investable assets outside of your qualified employer retirement plan(s) or IRAs.
Direct indexing accounts tend to also only be a good solution for investors whose taxable income places them within the 22% tax bracket (soon to become the 25% tax bracket) or above. The reason for this is that capital gains are taxed at 0% as long as total taxable income remains below the 22% bracket. Therefore, the tax benefits gained from participating in a direct indexing strategy as opposed to an index fund are relatively minor and are unlikely to be worth the higher fees associated with direct indexing. If unrealized gains on an index position become large over time, they can be trimmed back by realizing enough gains to put taxable income up to (but not in!) the 22% tax bracket while paying nothing in taxes on those gains.
Finally, direct indexing also tends to be a great strategy for investors who regularly incur large capital gain liabilities, or will be expected to incur them in the future.
For these reasons, I find that the following types of investors are generally the best fit for direct indexing: high net worth investors, business owners, and couples or individuals with high taxable incomes. More often than not, these investors will have the large amounts of taxable funds necessary to really benefit from a solution like this on a consistent basis. If you are an investor who does not fall into one of these categories, it doesn’t mean that direct indexing can’t be a good solution for you. Similarly, if you do fall into one of these categories, it doesn’t mean that direct indexing will certainly work for you either. Working with a competent professional to determine what is and isn’t in your best interest will be key.
