You know something is starting to go mainstream when different friends start asking if you've heard about it. My friends didn't ask if I heard some new song—they know better than to ask me about pop culture.
No, this was about the wonderful world of direct indexing! Yes, really. Direct indexing is a strategy where investors buy individual stocks to replicate an index, rather than purchasing an index fund or ETF.
It is starting to get more coverage as it can potentially improve after-tax returns by 0.50% to 1.50% based on various studies. Let's say you start with a $500,000 portfolio. An additional 1% compounded over 30 years could mean an additional $1.2M in savings simply from smarter tax management.
🧠 What you need to know
Direct indexing allows you to create a portfolio that tries to mirror the performance of a market index like the S&P 500 or Nasdaq 100, but with the flexibility to adjust individual stock holdings to fit your personal goals. Unlike investing in an ETF, direct indexing gives you full control over each stock in the index. This control allows you to reflect personal values or optimize tax strategies like never before.
When it comes to implementing direct indexing, there are several important areas to consider:
1. What is direct indexing?
2. How does it compare to traditional indexing?
3. Methods to implement direct indexing
4. The value of loss carry forwards
5. Benefits and potential drawbacks
6. How Mezzi can help manage a direct indexing strategy
Let's dive deeper into each of these areas.
What is direct indexing?
Direct indexing involves purchasing individual stocks to replicate a market index's performance, instead of buying a mutual fund or ETF that tracks the index.
This personalization can potentially lead to better after-tax returns and more alignment with your values.
It may seem intimidating at first, and financial institutions have every incentive to make it sound complex. Let's break it down and you can decide for yourself.
Why consider direct indexing?
The primary reason people choose direct indexing is to reduce their taxes with tax-loss harvesting. More specifically, you can offset gains by selling underperforming stocks in your direct index portfolio—a method that’s possible but harder to apply with a traditional index fund.
Direct indexing also allows for greater customization. If you’re passionate about ethical investing or want to avoid stocks in certain industries (like fossil fuels), you can adjust your holdings to reflect those values.
Ways to implement direct indexing
There are a few ways to set up and manage a direct indexing strategy.
Working with an advisor:
If you prefer a more hands-off approach, working with a financial advisor can help you implement direct indexing while benefiting from expert guidance. Advisors can manage the portfolio for you, helping you navigate the complexities of building a custom index.
Pros: Expert management, personalized advice
Cons: Higher costs, potential conflicts of interest
Keep in mind, some advisors will:
1) Require a minimum investment to access direct indexing and
2) Place your funds in a third-party managed fund rather than implementing the strategy themselves.
Your total fees could end up being close to 2% per year, considering advisor management fees plus fees for accessing the direct-indexing strategy.
Automated platforms:
Many financial platforms, including FREC, Double Finance, Wealthfront, and Schwab offer direct indexing as a service, where they automatically purchase and manage individual stocks based on the index you want to replicate. This simplifies the process and handles the complex tax strategies, such as tax-loss harvesting, for you. One challenge with these automated approaches is you'll be may be tempted to just "set it and forget it."
Fees are significantly lower at 0.10% to 0.50%, depending upon the strategy implemented. Minimums still apply and generally start at $20,000.
Pros: Lower costs than advisors, automated management
Cons: Less personalized, may have limited customization options
Do-it-yourself: Buying individual stocks
With this method, you manually buy and sell individual stocks that make up an index or collectively will close track an index, rebalancing and adjusting your portfolio as needed.
While this gives you complete control, it can be time-consuming and requires careful attention to trading costs and tax considerations. After all, it can be quite difficult to manage all 500 stocks. in the S&P 500.
An alternative is to focus on the largest stocks in each sector of the index. For instance, buying Apple for Technology, Johnson & Johnson for Healthcare, or JPMorgan Chase for Financials.
Pros: Full control, potentially lowest costs
Cons: Time-consuming, requires investment knowledge
Do-it-yourself: Buying sector ETFs
If you're looking for a simpler approach, consider buying sector ETFs that replicate the S&P 500. For instance, you could match the composition of the S&P 500 by buying the following sectors, example ETFs, and corresponding allocations.
1. Technology (XLK): 31.7%
2. Financials (XLF): 12.9%
3. Healthcare (XLV): 11.6%
4. Consumer Discretionary (XLY): 10.1%
5. Communication Services: 8.9%
6. Industrials (XLI): 8.5%
7. Consumer Staples (XLP): 5.9%
8. Energy (XLE): 3.3%
9. Utilities (XLU): 2.5%
10. Real Estate (XLRE): 2.3%
11. Materials (XLB): 2.2%
You could also decide to allocate more to a particular sector. When one of the sectors moves into a loss position, you could realize the loss for tax purposes and buy an alternative ETF with similar exposure. For example, sell XLK and buy VGT.
This approach has the same general pros as buying individual stocks. It doesn't offer as much opportunity for customization, but it is simpler to implement.
The value of loss carry forwards
Loss carry forwards are unused capital losses that can be applied to offset future capital gains or up to $3,000 of ordinary income per year. In direct indexing, frequent tax-loss harvesting can generate more loss carry forwards than traditional index investing. This tax buffer can enhance long-term after-tax returns by providing flexibility in managing your tax situation over time. Accurate tracking of loss carry forwards is crucial for maximizing their benefits and ensuring tax compliance.
Benefits and potential drawbacks
Benefits:
- Tax efficiency: One of the biggest advantages of direct indexing is the ability to use tax-loss harvesting. By selling underperforming stocks to offset gains in others, you can potentially reduce your tax burden.
- Customization: You can build a portfolio that reflects your personal values and goals by excluding or overweighting specific stocks.
- Control: You have more control over your portfolio relative to just buying an index, allowing you to make granular adjustments in real-time based on market conditions or life changes.
Drawbacks:
- Complexity: Managing individual stocks can be more complicated and time-consuming than buying into a fund, especially when it comes to rebalancing and tax strategies.
- Cost: Depending on how you implement direct indexing, the fees associated with outside management could impact your returns.
- Isolated account: If you already do any investing on your own, there will always be a do-it-yourself component to direct indexing if you want to truly maximize your opportunities to tax-loss harvest. For instance, if you use an advisor-managed direct indexing strategy but also maintain your own brokerage account, you'll want to consider offsetting gains and losses between the accounts to truly maximize savings.
🤝 How Can Mezzi Help?
No matter your approach to direct indexing, Mezzi simplifies the complexities and ensures you maximize the potential.
How could you use Mezzi to implement and oversee a direct indexing strategy?
1. Set up a taxable brokerage account to implement a direct indexing strategy with individual stocks or ETFs
2. Mezzi aggregates all your accounts—brokerage, retirement, and bank—into a single view, so you can see the full picture of your finances at a glance. This includes your automated direct indexing accounts like FREC or Wealthfront, or your advisor-managed direct indexing accounts.
3. Mezzi provides real-time alerts when positions move into a loss, guiding you through tax-loss harvesting opportunities while ensuring compliance with wash sale rules.
4. Track loss carry forwards that are eligible to be used in each year.
5. Track your exposure to each stock or ETF with Mezzi's Concentration insight and rebalance when positions move too far from your desired allocation.
