Key Takeaways
- Direct indexing is a strategy that helps you manage your taxes through investing in separate accounts.
- Because of the rise in passive investing and lower minimum investments for fractional shares, direct indexing has become more popular.
- Most advisors can provide their clients access to direct-indexing strategies.
- In a direct-indexing strategy, an investor would own part of an index, and based on the performance of the individual holdings, the losses will get sold and replaced with the unused holdings in the index.
- Most of the tax benefits for direct indexing are front-loaded, so eventually you will run out of losses to harvest.
Susan Dziubinski: I’m Susan Dziubinski with Morningstar. More advisors are using direct indexing as a way to help clients better manage taxes on an ongoing basis. Here today to discuss how the strategy works and what questions investors should ask before diving in is Jason Kephart. Jason is a senior principal with Morningstar’s Manager Research team. Hi Jason, thanks for being here.
Jason Kephart: Thanks for having me.
What Is Direct Indexing?
Dziubinski: Let’s start at the beginning, Jason. What is direct indexing?
Kephart: Direct indexing is a strategy to help manage your taxes. So, instead of investing in something like the S&P 500 through an ETF or a mutual fund, what you’re doing is opening a separate account, and you’re owning the stocks directly, and that gives you a lot more flexibility over how the taxes kind of impact you.
Why Is Direct Indexing Popular?
Dziubinski: Why is direct indexing gaining in popularity right now?
Kephart: On one hand you’ve seen the huge rise in passive investing. Indexing is all the rage across everything. If you look at flows, ETFs are raking in tons of money. So, I think that definitely helps, but also direct indexing itself isn’t really new, but advances in technology like fractional shares have helped bring the minimum investments down. I think companies have invested a lot in the technology to make it more efficient, and for them it’s easier to handle many more accounts and do many more types of indexes and customization options than you probably have in the past.
How Advisors Can Provide Clients Access to These Strategies
Dziubinski: Interesting. The most common way that advisors are sort of using direct indexing today is, of course, for tax management. How exactly are advisors providing their clients with access to these strategies?
Kephart: It’s through a platform. It could be your local brokerage. If you’re an advisor at a big wire house, there are options there, too. There are a lot of different avenues you can go through. Basically, anywhere an advisor would get access to an ETF or a mutual fund, they probably have an option for direct indexing, too.
How Does Direct Indexing Work?
Dziubinski: Explain how the strategy works.
Kephart: Let’s take the S&P 500. Instead of owning all 500 stocks, what this direct indexing strategy will do, it’ll own about 250, maybe 300, and it’s going to be a portfolio of stocks that kind of basically mimic the broader index, so performance should be somewhat similar, but to harvest the losses. When one of the individual stocks is trading below its cost basis, they’ll typically sell that stock, replace it with one of the 250 that weren’t originally in the portfolio to keep that composition similar enough to the S&P 500. What you’re doing is you’re locking in those capital losses, and you could use those to offset capital gains in the future. So, that’s really the tax management benefit. You’re really controlling for capital gains exposure.
Direct Indexing Behavior When the Stock Market Does Well
Dziubinski: It’s easy to see how this strategy works in a market where you have some stocks that are losing money. But what about a year where, in general, the stock market does pretty well?
Kephart: Even in years where the stock market does well, there’s always losses somewhere. It’s kind of like a duck sitting on top of the pond; it might look calm at the highest level, but those little feet are churning. And so you’re going to have areas of the market that are probably trailing and underperforming no matter what the period is. Especially if you’re looking on a year-by-year basis. We looked at it, it’s like anywhere between 20% and 25% of stocks generally have a loss in a year. So, there’s always some opportunity, but I think we’ll talk about a little bit about how those opportunities might not last forever.
What Happens When You Can No Longer Harvest Tax Losses?
Dziubinski: That’s my next question. Is there a point where this tax-loss selling really can’t be done anymore? Does the investor then in that case just have to keep putting new money into the account? How does this work?
Kephart: One way to keep the tax losses, the tax-loss potential higher, is to keep regularly investing in the portfolio. But even then, because stocks go up over time—that’s kind of why you’re buying them in the first place—eventually, you are going to run out of losses to harvest. Some studies have shown it happens over between five and 10 years. And so basically, most of the tax benefits are going to be front-loaded, no matter what. But that is one of the risks you run into with direct indexing, if you own it for a very long time, eventually, you kind of get locked into what essentially mimics an ETF, but you’re paying slightly higher fees.
How to Keep the ‘Tax Wheel Spinning’
Dziubinski: Let’s say I don’t want to keep putting money into this investment. What other things can advisors suggest that their clients do to keep this tax wheel spinning?
Kephart: Aside from continuing to put money in the account, which is to reset your cost basis lower, so that kind of resets the clock a little bit, they can make charitable donations of their stocks. That’s one way to get rid of them. I know some firms are looking at ways to kind of convert from direct indexing to something like an ETF through in-kind redemptions, which, again, would give you kind of a release valve that way that wouldn’t force you to kind of liquidate the account, realize all the capital gains, which is really not what people are using direct indexing for in the first place.
Questions to Ask Advisors About Direct Indexing
Dziubinski: Last question, Jason. What are the questions that a client should come to their advisor with if they are considering recommending direct indexing?
Kephart: I think some of the main things are, we talked about the exit strategy. You kind of have to have one in mind. What are you going to do if you do run out of losses and essentially the portfolio gets locked up in gains? And also, one of the benefits is being able to offset capital gains. So, where are those other capital gains going to come from in the portfolio? What’s kind of the broader strategy around this tax management? Those are the kind of things I would think about. We’re also seeing it expand beyond just indexing. And now active managers are starting to offer SMAs that can be tax managed, too. So, I’d also ask if there is a benefit there? So, there might be some other opportunities for tax management outside of just passive investing.
Dziubinski: Got it. Well, this is very interesting stuff for tax management. Appreciate your time, Jason.
Kephart: No problem. Thank you.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
Watch 3 Stocks to Sell and 3 Stocks to Buy in March for more from Susan Dziubinski.
