Generally, investors tend to overvalue their level of skill or influence in regards to their portfolio performance. Just being in or out of the right asset class or market accounts for an enormous percentage of your overall returns. The security selection inside those makes for a minor attribution to performance.
That’s more or less the premise for passive indexing.
Put the odds in your favor. Delivering outperformance through security selection can be done. If you can consistently do it over time, open up a fund. You’ll be rich.
Control what you can control. If we simply recognize that picking stocks probably lowers our return, then abstaining from picking stocks relatively improves our outcome.
So, what then? The change in investment value is not the only input for your actual return. The IRS has to get their cut too.
If you can produce the same investment returns, but do it more tax efficiently, you’ve increased your actual performance.
Enter direct indexing. Direct indexing is a strategy that adheres to the philosophy that actively picking securities isn’t the best way to pursue enhanced returns. Tax efficiency is.
Direct indexing essentially peels back the fund wrapper of an index fund and owns the same allocation of the underlying securities in your portfolio. Then, as the securities change in value, the losers are tax loss harvested to bank tax losses along the way, then rebalanced in the future so the basket of securities closely tracks the gross returns of the index.
It makes a lot of sense and it does work. But, there are always some drawbacks.
First, many of the direct indexing providers charge a fee similar to what a mutual fund might charge. So, all things constant you’ve got to make that up in tax savings to get back to where you were if you just owned the low cost passive index fund instead.
Second, if markets are just not volatile, there won’t be relatively as many losses to be taken.
Third, at some point all of the losses that can be had will basically have been taken. As we know, markets tend to go up over the long term. Logically, we’ll have some positions that essentially never go to a loss position so they were never sold. Then, the positions that we have tax loss harvested will generally recover. Or at least a good portion of them will. Eventually, we are left with a portfolio of tons of stocks that all have net unrealized gain positions. It can be tough to manage at that point with anything being touched triggering a gain.
This is where the direct indexing strategy becomes difficult to unwind. You could just eliminate the provider to save the fee, but it doesn’t really change that you’ve now got hundreds of stocks in your portfolio that you’ve got to try to manage to stay in line with the index, all with a gain in them.
Doesn’t mean it’s not worth it, but it is a strategy that is probably pushed a little more than it should be. Caveat here that I’ve been focused on describing long-only direct indexing. There is long-short (130-30) that probably does a better job of creating tax losses for a much longer duration, but it does require the investor to be comfortable with short positions.
Who is it right for?
Someone in a high marginal tax bracket that intends to regularly add lots of cash to their portfolio. Basically, they’ll delay the point in time when all losses are taken simply because they are giving a fresh batch of cash each year to establish its own basis.
Someone with a highly concentrated stock position they are attempting to reduce, but need losses to offset some of the gains.
Someone who’s had a large liquidity event that likely carried a capital gain with it. Same rationale as the concentrated stock person, but with a shorter window to create tax losses.
Someone who is going to hold a large portion of the portfolio until their death to receive a step-up in basis. In this scenario, the point in time where only gain positions remain is less relevant as they have used the tax losses already and can simply hold the gain positions indefinitely until the step-up in basis is received and their heirs can do whatever they want with the positions then.
Someone who is charitably inclined. Instead of holding the gain positions until their death, they become the mechanism for donating to charity. The gain is sidestepped, they receive a charitable deduction, and the charity gets funds for operations. Win, win, win.
Direct indexing can be great if it fits, but like most financial products that get a little buzz it’s not a one-size-fits-all.