Implementing direct indexing using sector ETFs

Investors in a direct-index portfolio are looking for the passive return of an index with the added benefits of tax efficiency. They achieve that by owning the individual securities of an index, rather than a mutual fund or ETF that tracks the index.

We recommend taking this increasingly popular approach to passive investing and simplifying it.

GROWING MORE POPULAR

Traditionally with direct indexing, the investor holds a portfolio of individual stocks that represent an index, like the S&P 500. It is direct in the sense that it involves ownership of individual stocks rather than ETFs or index funds.

Investors are free to customize their holdings to meet their needs. For example, if an investor has concentrated exposure to a single stock in other parts of their portfolio, and it appears in the index, they may choose to eliminate that stock from the direct-index strategy. Over time, by owning individual stocks instead of an index-tracking fund, along with regularly rebalancing, the investor should create tax savings opportunities with greater control of their underlying holdings.

The popularity of the strategy is growing. Assets in a direct-indexing strategy jumped from just over $100 billion in 2018 to well over $300 billion in 2021, according to FactorResearch. Research and analytics firm Cerulli Associates sees direct-indexing assets under management closing in on $400 billion before 2023, and projects an asset growth rate of 12.4% through the next four years.

But the strategy is not without its flaws, as well discuss.

NIMBLER THAN ACTIVE MANAGEMENT

Its tempting to compare direct indexing to active portfolio management. A client who eliminates or underweights certain stocks they consider undesirable from the universe of a benchmark index like the S&P 500 is doing exactly what every U.S. large-cap fund manager is doing, the CFA Institute says in an assessment of direct indexing. The main difference? Active portfolio managers make tactical changes to their portfolio to create alpha, or better returns, relative to the benchmark index they are compared against, rather than simply following the index. They do this without regard for individual investors needs. Direct indexing seeks to track the same return of the index but creates tax savings along the way to benefit the individual investor. Over time, this approach should create a better after-tax return versus holding the same index via a mutual fund or ETF.

How? Heres an example:

If an investor holds an S&P 500 index fund for 10-plus years, based on historical performance, they will likely have large unrealized gains. When rebalancing their portfolio or withdrawing money from the fund for cash flow needs, they will face a capital gains tax burden each time they sell the fund.

If the investor instead held a representative set of stocks tracking the S&P 500 index over that same period, the portfolio will likely have had stocks that went up and stocks that went down, even though as a whole the index was positive over that period. Such is the reality of how indexes work. By owning the individual stocks, an investor, or the strategy manager, can sell and replace the stocks that have gone down with another stock in the same industry or sector of the S&P 500. As such, the investor locks in a capital loss for tax purposes, while maintaining their index exposure and capturing the same performance of the index as a whole.

The holder of the index fund or ETF does not have that advantage.

But it can be hard to keep direct-index portfolios from drifting from their benchmark index. Over time, swapping stocks in and out can create portfolios that no longer behave like the indexes they are supposed to replicate. This gives investors using direct indexing two choices:

1. Do nothing, and risk skewing performance versus the index, or
2. Rebalance the portfolio to the target index, which can pose timing issues and create undesirable tax consequences.

We believe in helping clients avoid this dilemma altogether by taking a strategic approach to direct indexing. Instead of owning individual stocks, we recommend using ETF sector funds. Because these sector funds are available from multiple fund companies (State Street, BlackRock, Vanguard, Fidelity, etc.), and each of their funds hold very similar underlying holdings, we are able to sell funds held at a loss and replace them with another sector fund, thereby maintaining virtually the same sector exposure and underlying holdings, instead of eliminating a stock altogether from the index, the way traditional direct indexing does.

TAX-LOSS HARVESTING

Our sector ETF approach to direct indexing maintains the potential for tax-loss harvesting. This involves selling an investment currently held at a loss, thereby realizing the loss. These capital losses are used to offset capital gains on other investments in an investors portfolio. If the investor has no capital gains in their portfolio in a given year, the investor can use a limited amount of the capital loss to deduct from their income, while the remaining capital losses carry forward to the next year. Tax-loss harvesting is particularly useful when you consider research from Parametric Portfolios that suggests taxes are a bigger drag on long-term performance than fees or trading costs.

Although tax-loss harvesting is a powerful tool for managing after-tax returns and preserving wealth, IRS rules can complicate the timing of transactions involving substantially identical securities. Because of this, deciding which investments to sell at a loss, how to best replace those investments, and subsequent management of the portfolio can be difficult. As such, consulting with a professional can be enormously beneficial.

THE BOTTOM LINE

Theres more to direct indexing than simply the tax-loss harvesting benefit. This approach can also lead to:

Improved Outcomes. By eliminating third-party manager fees, diversifying across more indexes, maintaining a closer resemblance to an underlying index and reducing the number of securities a client owns, this approach seeks to improve upon the concept of traditional direct indexing.

Better vigilance. The process of monitoring a portfolio for its tax efficiency is ongoing. If you manage your clients wealth holistically, you will have better insight into how the direct-indexing strategy will impact the client in terms of both tax planning and investment strategy.

Tactical philanthropy. Direct indexing can also play a part in charitable giving by producing better after-tax returns and pairing the results with a well-constructed philanthropic strategy.

We believe advisers should focus on greater client outcomes. This holds true whether discussing comprehensive financial planning or investment strategies to feed those plans.

Matthew Liebman is co-founder and CEO of Amplius Wealth Advisors in Blue Bell, Pennsylvania.