One of the biggest fears that people have with money is running out of it. It doesn’t matter if you have a lot of money or a little. Running out of money is anxiety shared by many. Think for a minute, do you or someone you know still hide cash at home? Why do you think so many people hide money at home? Three words tell you why: simplicity, control, and confidence. Direct indexing shares these principles.
That is why direct index investing is becoming more popular: simplicity, control, and confidence. Today we’ll explore the simple mechanics of direct indexing. As well as highlight the four primary direct indexing benefits that give investors significant control of their investments. Consequently, you will see why more and more people are putting their confidence in direct stock ownership instead of ETFs or mutual funds.
Direct index investing is simple to understand. The fees are simple. There are no accounting fees, legal fees, or marketing fees, such as 12b-1 fees. If you use the right custodian, there are no commissions or trading fees either.
You own stocks that replicate an index you like. You only use a custodian to purchase and hold the stocks. Consequently, you have control over those stocks. Owning stocks directly gives you control over when to buy and sell the investments. We’ll look at how the control of investments brought about by direct indexing can affect your financial returns in a moment.
Lastly, the simplicity and control over your assets can give you confidence in how you use your assets. It is like the difference between renting and owning something. You have more control over what you own rather than what you rent.
Although, you do not have to go it alone. You may choose an investment advisor to guide you. Consider a fiduciary advisor who will put your interest first. At some point, if you choose to change advisors, you do not have to sell your stocks. You are always in control.
How does direct indexing work?
Direct indexing brings stock ownership full circle. In the early 1900s, to own stock or ownership in a company required a substantial amount of money. By the 1940s, stocks were being grouped together by a money management team, and shares of that group were sold. Those pools of stocks are regulated by the US government and called mutual funds. By the mid-1970s, stocks were put together in some mutual funds based on their value in the overall market. That was the beginning of index funds. By the early 1990s, some money managers began to group stocks from sectors of the economy to form a company that could be sold publicly like any other stock. That was the beginning of the exchange traded fund or ETF.
The first direct indexing
In the same time, as the beginning of the ETF, some investors decided to side-step the creation of a corporation to own a sector of the economy or an index. These investors decided to hold the stocks from the index directly. This was the beginning of direct indexing.
The cost of direct indexing
In the beginning, direct indexing was primarily for investors that had a lot of money. Investors had to buy whole shares, and to own enough stocks to replicate an index was expensive. Today, technology has made direct indexing available to investors with smaller sums of money. It has also reduced the cost. Since most custodians that hold stocks have eliminated or reduced the cost of buying and selling stocks, direct indexing has become more widely available.
The only fees in direct indexing are either from the investment advisor or for the research and management of the index model. As an example, my firm’s advisory fees range from an annual fee of 1% for smaller investors to 0.40% for larger investors.1 Factoring is a technique of using Independent research and management for index modeling. The cost of factoring ranges between 0.30% to 1.00%. The only other charges might be if you decide to trade stocks in off-hours, you want a wire transfer or some other special request. All fees are very transparent. The maximum fee possible would be for a smaller account, and investors would need to weigh the higher cost for their size of account.
An interesting thing about direct indexing is that in the right circumstances, the benefits may justify the additional fee through tax efficiency. We will discuss this more in the following section on tax harvesting.
Two types of direct index investing
There are two types of direct index investing: pure direct indexing and factor management. Pure direct index investing is the simplest form. It involves only buying the stocks of an index in proportion to its relative index. You can choose to allow the stocks in the index to adjust when the index adds or deletes stocks. Adjusting holdings based on changes to an index is reconstitution. Alternatively, you can hold the stocks until you and your advisor decide to change. Pure index investing is the least expensive.
Factor investing can be as simple or complex as you choose. You can change direct index portfolio holdings for a variety of factors, which may be principle investing based, risk-based, or based on fundamental or technical analysis. If you choose to be more hands-on with your investments, it can be more complicated, but you are still in control. The research for the factors can have a cost involved. This is where you need to weigh the cost of the research for the perceived benefit.
Reducing money management anxiety
Reducing the anxiety of managing personal finances can be overwhelming. I have encountered people that are so overwhelmed with the complexity of managing their savings that they put everything into cash. Direct indexing is a money management technique that may give investors simplicity, control, and confidence.
This is a disclosure
However, I want to be perfectly clear. Any investing still contains risk. And the past performance of an investment is not a guarantee of future performance. This information is not financial advice. It is only educational in nature, before investing read the disclosures to understand the risk and cost.
The four unique features of direct indexing
The control that direct indexing offers can be more appealing to investors that are looking for customized solutions to money management issues.
- Avoiding reconstitution
- Principle-based investing
- Reducing concentration
- Tax management
Let’s take a more in-depth look at how these features may be able to help you.
Reconstitution is when an index changes stocks within the index. The frequency of changes differs from one index to the other. For example, the S&P 500 reconstitutes whenever a change is necessary. Changes can occur because of takeover, mergers, demergers, bankruptcy, change of domicile, or other organizational changes. Reallocation for the S&P 500 occurs quarterly because of changes in company valuation.
All these changes mean stocks are added and deleted from the index. If you own an index fund that is replicating the index, the changes can trigger taxable events within the index fund. If you own the index directly, you can choose if you want to make a change and base it on your tax situation.
Investing based on morals and beliefs has become a prevalent aspect of investing. Direct index investing gives investors significant control over the type of companies that they own. Suppose that you wanted to invest in the NASDAQ 100, the one-hundred largest companies in the country. However, after looking at the list of one-hundred companies, you decide that you do not like the causes that one or more companies support.
You can choose to selectively choose not to own those companies. You can take a broader approach to the strategy as well. In other words, you could decide to eliminate specific sectors that you do not agree with. For example, you could choose to remove alcohol or tobacco stocks. In fact, there are several other factors that you can choose to eliminate. If you have an interest in eliminating specific stocks or stocks based on factors you choose, talk to me, and I can guide you to the option you are looking for.
Reducing the concentration of a stock or a group of stocks can be important for many reasons. You may choose to eliminate certain stocks because you think there is an added risk. For example, the S&P 500 is dominated by tech stocks. If you feel that a high concentration in tech stocks is more risk than you want, you can reduce your exposure in your direct index selections.
Additionally, you may work for a company like Exxon and own a significant amount of Exxon stock. As a result, you may not want more of that company’s stock in your direct index selection.
Some people’s profession may require that they eliminate certain publicly traded companies from their personal holdings. For example, if you are an attorney who is litigating a public company, you may not want to hold that company’s stock because it would pose a conflict of interest. Or, you may work for an accounting firm that is auditing a public company within an index. You do not want to own the stock of the company you are auditing because it is a conflict of interest. A direct index can selectively eliminate stocks based on your needs.
One of the most financially beneficial reasons for using a direct index investing strategy is for the tax benefits. If you own a mutual fund, it is possible to be taxed on capital gains even when the fund is down in value. Phantom capital gains occur when a portfolio manager is forced to sell stocks the portfolio has held for a long time to meet shareholder redemptions. This often happens when the stock market falls significantly. Owning a direct index avoids being forced to sell a stock. Direct indexing avoids the need for selling to meet redemption needs.
Tax effects of reconstitution
Above, we discussed avoiding reconstitution. You may recall that reconstitution is the change that occurs within an index. Those buys and sells are reflected within any index fund that tracks the respective index. Those changes can cause taxable events. Those taxable events can be avoided by owning an index directly.
Lastly, using a direct indexing technique can allow an investor to use tax harvesting. Tax harvesting is selectively selling stocks that have losses. Those losses can be used to offset taxable income and can be used to boost the overall taxable gain when it exists. There are annual limits to claiming taxable losses. You should review those limits with your tax advisor.
The only way to use tax harvesting with a mutual fund or an ETF is to sell the entire portfolio. Using a direct index investing technique allows investors to sell stocks that have losses. That is repeated because it is significant. Let’s say that you own the NASDAQ 100, and several stocks have losses. You can sell those stocks to take advantage of the losses against other gains or your income. As long as you do not go back into that stock or a similar stock within 30 days, you can take advantage of the tax loss.
There are a variety of claims on the effectiveness of tax harvesting. Some advisory firms have claimed to be able to add over 6% per year. As a result, they were penalized by the SEC for falsely overstating their claims.2 Conversely, other firms have stated that the benefits of tax harvesting are more modest at less than 1%.3
Form reasonable expectations
Tax-loss harvesting is one of several unique features of the direct indexing technique. The benefits are different for each person because each person’s tax situation is unique. In determining the value of tax-loss harvesting, ask yourself if you could benefit from a possible increase in your overall return that is less than 1%. Form a reasonable expectation of the value of tax harvesting. Direct investing can be a valuable investing technique, but it is not for everyone.
Is it right for me?
At this point, you may be wondering if direct indexing will work in your situation. There is an easy three-step process to find out.
- Discuss your personal financial vision and needs with me.
- Work with me to create a custom direct index based on your needs.
- Implement the plan, and I’ll keep you updated every step of the way.
You know if direct indexing is for you if you can simply understand the process and the cost. You maintain control of your account. And you are confident that the process will help you financially. Remember that investing does have the risk of loss. And, the past performance is not a guarantee of future results. The information in this article is for education purposes only and should not be considered advice. If you wan
1 Richards, Van. “Fees.” Richards Financial Planning, LLC. Last modified January 12, 2020. https://richardsfinancialplanning.com/how-we-charge-fees/.
2 U.S. Securities and Exchange Commission. SEC charges two robo-advisers with false disclosures. Washington, DC, December 21, 2018. https://www.sec.gov/news/press-release/2018-300.
3 Loder, Asjylyn. “Beware the bold claims of tax-loss harvesting.” Wall Street Journal (New York), n.d. https://www.wsj.com/articles/beware-the-bold-claims-of-tax-loss-harvesting-11555153200.
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