(etf.com) - Direct indexing is forecast to attract assets at a faster pace than exchange-traded funds, according to a recent report by Cerulli Associates. Much like ETFs far outpaced mutual fund growth because of their general superiority, could direct indexing be the next wave? Let’s compare the two and then I’ll give my take.
Cerulli Associates finds that only 14% of financial advisors are aware of, and recommend, direct indexing solutions to clients. Thus, I’d better explain what it is. Using the S&P 500 as an example, rather than buy an ETF like the SPDR S&P 500 ETF Trust (SPY) or the Vanguard S&P 500 ETF (VOO), a direct indexing platform is a computerized, separately managed account that can buy a sample or all 500 of the individual stocks that make up this index.
They typically buy according to market capitalization, thereby coming close to replicating the index. In fact, with the introduction of fractional shares, this can be done with a relatively small amount of money.
Why is direct indexing better than just buying SPY or VOO? It has several advantages.
First, direct indexing has tax advantages. In most years, the stock market goes up, so one can’t tax-loss harvest with the ETF. But even in periods where the index gains, there will be some losers.
As an example, according to a Vanguard study, the S&P 500 gained 9.76% in the fourth quarter of 2021, yet there were still 133 individual companies that lost value during that time. The computerized direct indexing program can sell those losers and harvest the losses, which gives the investor a tax savings.
Those same stocks can’t immediately be repurchased, as the IRS considers that to be a wash sale and the loss is disallowed. It can, however, buy similar companies in the index and then, 31 days later, buy back the stock used for the tax loss. You can’t harvest this loss within the ETF itself.
So when you get your 1099 at tax time, you can offset those capital losses against other capital gains, such as sales of your ETFs. If you don’t have capital gains, you can typically take a loss up to $3,000 and carry forward the remainder to future years. Vanguard points to research claiming this tax alpha adds 0.2% to 1% annually in extra returns.
A second benefit is customization. If, for instance, you wanted to exclude the largest five oil companies in America, many direct indexing platforms allow this. It could be your own customized ESG fund.
Maybe a better reason might be concentration. Say you worked for Apple (APPL), which comprises 6.3% of the S&P 500 index. You’ve got your salary, bonus and stock incentive plans dependent upon the stock’s performance. So rather than buy more Apple stock through an ETF, you could exclude your employer and perhaps a few stocks in the same sector.
Finally, both fees and account minimums are plunging. Last year, I bought a Fidelity Direct Indexing product that has only a 0.40% annual fee with only $5,000. It tracks a Fidelity large cap index of 250 US companies.
About Those Taxes ...
But is direct indexing better than ETFs? Generally they are not, in my view, at least not compared to the best ETFs. Sticking with the S&P 500 as an example, Vanguard’s VOO has a 0.03% annual expense ratio versus typically at least 0.40% annually for direct indexing.
While that 0.37 percentage point differential could certainly be made up from the benefit of tax-loss harvesting in the early years, it likely won’t continue. That’s because the stock market generally moves up in the long run, so each year there is less and less tax-loss harvesting. Yet the fees continue.
When clients come to me after being in direct indexing for several years, they usually have very little in the way of tax losses from the account. In addition, they have huge unrealized gains since the losses have been realized and only the winners are left. And there is always the possibility capital gain tax rates will go up, which eventually costs you more. This is far from tax alpha.
Typically after a few years, the tax benefit is minimal, and all that is left are fees and complexities. The 1099 tax form on my little $5,000 direct indexing experiment is 86 pages!
Conclusion
Direct indexing is generally not as good as buying broad ultra-low-cost index funds. That said, it could be beneficial in certain circumstances:
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You want to donate to charity in a few years so you can harvest the tax loss and then donate the appreciated securities to the charity, thereby never paying taxes on the appreciation.
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You currently have large taxable long-term gains at the 23.8% marginal federal tax rate (20% +3.8% investment income tax) but soon will be in a lower rate.
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You are in a high tax bracket but have a very short life expectancy and the kids will soon inherit the money with a step-up basis.
I used the S&P 500 as an example to give the benefit of the doubt to direct indexing. Total stock index funds like the Vanguard Total Stock Market ETF (VTI) or the iShares Core S&P Total U.S. Stock Market ETF (ITOT) give you even more diversification. Direct indexing doesn’t work as well for mid and small cap stocks since bid/ask spreads are higher and the turnover takes from returns.
Direct indexing is good. It’s just generally not as good as owning broad ETFs.
By Allan Roth
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for Barrons, AARP, Advisor Perspectives and Financial Planning magazine.
