Sam's Corner: Direct Indexing
What is Direct Indexing & and Why You Should Care
This may be the most biased statement in the world, but investing is cool. The product structure you invest in is also cool and extremely important to get right, especially in after-tax accounts. There are many product structures available to the investing public: mutual funds, exchange traded funds (ETFs), unit investment trusts (UITs), individual stocks, bonds, options, certificates of deposits (CDs), and countless others. One product type that I omitted is something called a separately managed account (SMA). Within this product type are strategies largely known as direct indexing or custom indexing.
A Quick Note on What a SMA is: These are strategies professionally managed by money managers similar to a mutual fund or ETF. The difference is that instead of one line item lumping all the investments into a single name, the investor directly owns all securities in the strategy. Using a stock SMA as an example, in a mutual fund or ETF this would appear to be one item. In a SMA, one strategy could show 20 to 500 individual stocks owned directly in your account. This provides transparency for the investor into which positions the investment manager is buying and selling in your account.
We love transparency. Combine this with tax efficiency, and we have a match made in heaven. Enter direct indexing. A direct index is a type of SMA that buys a passive market index, such as the S&P 500, where you own each individual stock in it. Originally, direct indexing was designed to focus on customization for clients looking to screen out investments that conflicted with their personal values. Religious organizations used them to exclude certain investments, and individuals did much the same with “sin stocks” such as tobacco, gambling, or weapons manufacturers. The product is still widely used for these reasons, but the side benefit of tax efficiency soon became the star of the show.
In a mutual fund or ETF, when the value goes down, we look at our balances, lick our wounds and hope for an up day tomorrow. In a direct index, we benefit from both poor and great days in the market. The down days are the difference – since we own the names in the index, any of those which may be down in value, we can sell at a loss. We can use these losses to offset comparable capital gains in the same tax year or carry them forward to future tax years to match future capital gains.
How Does it Work?
On down market days, the manager, often a trade algorithm, identifies losses in the account and sells those positions to realize the loss. There is a Wash Sale rule to be aware of. Essentially, if you buy the same holding back within 30 days of selling it, the IRS treats the position as if you never sold it at all; meaning you keep your original cost basis, not allowing you to realize that loss. The manager works around this to ensure positions are not violating the wash sale rule, while replicating a passive index with a margin of tracking error to that index (usually around 1% up or down, but again varies by situation).
Keeping with the S&P 500 example, the manager may own 300 individual securities in the account at any given time. Those not currently owned, are intentionally excluded to avoid overlapping exposure to be rebalanced into.
This is boring, but incredibly powerful. Depending on income, long-term capital gains can be taxed at 0%, 15% or 20%, while short-term capital gains are taxed at your ordinary income rate. However, if we have losses pooled from those poor market days in our direct index, we can use them to offset the equivalent amount of gain when realizing the sale of an asset in investment accounts. This generates what is colloquially known as, “tax alpha”, which is a fancy way to say, excess return from paying less in taxes. In qualified accounts (Traditional IRAs, Roth IRAs, 401k’s, SEP IRAs, etc.), this doesn’t matter since gains are not taxed until we withdraw funds. In after-tax accounts, it is a powerful tool, enabling us to rebalance concentrated positions with unrealized capital gains, or to sell other holdings that may have done well, but we don’t particularly love anymore, without triggering a tax hit.
Investment minimums vary for each direct index provider and the index they try to recreate. Consultation with a tax professional is advisable when discussing assets externally to those we may manage.
