Direct indexing is the process of buying the individual stocks in an underlying index (such as the S&P 500) directly in an account vs just buying the index fund or ETF.

But why would someone do this? Common reasons are advanced tax-loss harvesting opportunities and customization. Watch this video to learn more!

Transcript:

On today's video, we'll be talking all about direct indexing. What is it, who's it for, and who's it not for? I'm Chris Kaminski, co-founder, and partner here at Consilio Wealth, where we specialize in working with technology professionals, specifically at Amazon, Microsoft, Meta, and Google.

Direct indexing is a process of buying the individual stocks in an underlying index directly in your account. For example, the S&P 500. So instead of buying the Vanguard S&P 500 fund, which a common ticker would be VOO, that index fund buys the 500 underlying holdings of the index and is designed to track it. You would instead buy all of the individual holdings, the 500 holdings in your account. Why would you do this? The main benefits are A, tax loss harvesting opportunities, and B, customization.

Let's talk about tax-loss harvesting. Tax-loss harvesting is a process where you can sell certain things that are down and replace them with other things to book the capital loss. When you own all of the underlying holdings of the index, you can be fairly confident that not all 500 of the holdings in the S&P are going to go up exactly, say, 4% on the year to create an exact 4% rate of return on the index. You might have some holdings in there that are up 10, 20, 30, 50%, and you'll have some holdings in there that are flat to negative or negative a lot, and all of that averages out to say that 4% return.

Again, just staying with the example. The concept here is that the holdings that have gone down can be tax loss harvested, and if those holdings are sold and swapped appropriately, the total investment still tracks the underlying index very tightly, but the net result is you have tax losses. These tax losses or capital losses can be used against other capital gains later when you are ultimately liquidating from this account many years down the road, or they can be applied against other capital gains elsewhere.

Let's say you have a lot of concentration in say Amazon stock. You have a big capital gain and if you sell it, you book a six-figure capital gain. Well, if you can over time create tax losses in a direct indexing account, those losses can be applied against your capital gain on sale and no or less taxes are due on that sale. The second benefit is customization maybe you work for a big tech company, maybe you already have a lot of exposure to Meta stock and so you could design an index and you could exclude Meta stock from that index.

So, it's everything in the S&P, less meta, another example would be customization for ESG or environmental and social governance constraints. The benefit there is that you might not want to invest in certain companies that have, say, child labor practices or non-diverse boards or whatever it might be. You can exclude companies that don't meet your criteria and then buy the underlying companies that do.

Of course, if you do this, you do run the risk of what's called higher tracking error or the risk of the underlying holdings not keeping up or tracking with the actual benchmark, but if that ultimately allows you to hit your investment goal of investing in the things that are important to you, then the tracking of the index is a secondary component.

Where is this a good fit? Generally speaking, this is a good fit for high-income individuals that have a lot of capital gains. Generally speaking, for most of our clients, they're already fully maxing out their 401ks, including the after-tax, and they save a lot of money outside of their retirement plans and so they start to accumulate very large balances in non -retirement accounts. You're paying taxes on dividends, you're paying taxes on interest, you're paying taxes on capital gains each and every year.

Tax loss harvesting is incredibly valuable because you can at least offset some of the capital gains that are derived from your accounts, maybe even all of them. Something to note here, just buying the index is a great way to say track the S&P 500. You can still tax loss harvest the S&P 500, but it's difficult to sell that position and buy something that's very similar because the IRS requires you to buy something that is substantially different. It's hard to say, sell the Vanguard S &P 500 fund and buy the Fidelity or iShares S &P 500 fund because that doesn't meet the definition of substantially different. That's the same thing.

So, the advantage of selling one stock for another stock is that those are completely different than they do qualify for tax loss harvests. Further, we can only tax loss harvest in a down year at the index level. Meaning, let's say the market is down 10% this year. You could potentially tax loss harvest your trade if you bought January 1st, and you have a negative 10% year. But if the market is largely up throughout the entire year and doesn't have much negative, which can also happen, once again, some of those underlying 500 holdings are definitely negative throughout the year could be swapped versus if you own the underlying index, which has only been positive, you can't tax loss harvest in that given year.

So again, these are just further benefits. Okay, what are the downsides? Over time, this strategy has diminishing returns. Meaning, if you fund your account one time, you'll likely see benefits of this over roughly a five-year period. After that period, you've kind of squeezed out all of the losses because ultimately stocks tend to go the right direction and so over that five-year period, it's known that the strategy has diminishing returns doesn't mean that it's not worth it, but it does have diminishing returns.

So, this is best suited for people who are funding their accounts over time, because when you're funding your accounts, you're consistently adding more money, typically at higher cost basis in the market. And ultimately then you have this new five-year period roughly on those new funds that you can execute losses.

Secondly, it's worth noting that this strategy is a newer strategy in the last handful of years with the advent of commission-free trading. Years ago, when you had to pay nine bucks or 12 bucks or 15 bucks for every single stock trade, this strategy only made sense for huge, huge accounts. I'm talking $250 million accounts and up, big accounts and the reason is because if you did the math on all the tax savings minus the tens of thousands of dollars that you would have paid in commissions every year, it still would have netted out positive when we're talking big numbers but now with the advent of commission-free trading, these types of swaps are totally free to the investor.

Now, the strategy isn't totally free. There are various providers that do this. They all will charge something. So, it is notable that direct indexing is more costly than just buying the index. Now the Vanguard S&P 500 fund is 0.03 % internal cost. It's very, very low. If a provider costs anywhere from 0.15 to 0.25 % in order to execute this strategy, it is definitely more expensive than just buying the underlying index. But studies would suggest that implementing tax loss, assuming you're in a high tax bracket, and again, assuming you're funding the account, et cetera, it does make good sense.

All right, I hope this video was helpful and clears up any questions around direct indexing.