Should You Direct Index?

With Open Arms

Last month, I described the latest investing trend, in "Direct Indexing Is Coming Your Way." Over the past two years, Vanguard, Charles Schwab SCHW, Fidelity, BlackRock BLK, Morgan Stanley MS, and Wealthfront have acquired direct-indexing capabilities. Among that group, Schwab, Fidelity, and Wealthfront have launched programs for do-it-yourself investors. Their annual fees, respectively, are 0.40%, 0.40%, and 0.25% of assets. Schwab and Wealthfront stipulate minimum investments of $100,000, while Fidelity requires much less, at $5,000.

Direct indexing refers to purchasing either every stock of an entire equity index or, more likely, a representative sample. That is, rather than buy a single fund, the investor will own shares in dozens of companies. Direct indexing would have been prohibitively costly when brokerage commissions and stock spreads were large. Today, though, transaction costs are nigh-on extinct. A once-exclusive service is available for all. (The invention of fractional-share trading has also been critical.)

The Promises

The page for Schwab's offering, called Schwab Personalized Indexing, summarizes the pitch for direct indexing. To quote the company's marketing material, its program is:

1. Customizable Select an index for the market exposure you prefer, including an environmental, social, and governance option. You can also exclude a limited number of stocks to reflect your preferences.
2. Tax-Efficient Tax optimization seeks to minimize tax liabilities and have your portfolio potentially outperform the index on an aftertax basis.
3. Professionally Managed Portfolio managers at Schwab Asset Management leverage proprietary technology to optimize your portfolio and monitor it on a daily basis.

An unconvincing list. Because they are available in hundreds of flavors, standard index funds can better reflect an investor's personal tastes than can the three indexes used by Schwab's direct-indexing service, even if those benchmarks are supplemented by the ability "to exclude a limited number of stocks." With taxes, as I will shortly explain in further detail, many exchange-traded funds are already equally efficient. And those funds, of course, are also "professionally managed."

However, there is more to direct indexing's tax promise than first appears. While it is true that there is limited reason to adjust a benchmark's holdings, and that the boast of professional management is immaterial, since the same attribute applies to index funds, the strategy's tax benefit cannot be so readily dismissed. Under the right circumstances, investors certainly should be direct indexing.

Tax Matters

To start at the beginning: All investments contained within taxable accounts (forget about direct indexing in tax-sheltered locations, such as 401(k) plans or IRAs) must distribute their aftercost income, that being interest receipts or dividends. With investment income, there can be no escape from the taxman.

Although the same rule applies to capital gains from the sales of securities, this liability, unlike income, can often be controlled. Stock shareholders may avoid taxes merely by refraining from transactions, or they may do so by using the more complex method of offsetting their profitable trades with realized losses.

The latter is achieved by both ETFs and direct indexing, albeit in different fashion. ETFs can manage their capital gains through their "creation-and-redemption mechanisms." (This article provides the details.) The process for neutralizing capital gains when direct indexing is simpler to understand. When one stock is sold for a profit--which does not often occur with indexing strategies--a direct-indexing service can offset that gain by selling a corresponding loser.

In short, an ETF that invests in a conventional index and a direct-indexing program arrive at the same tax destination. In each case, the portfolio receives taxable income, but it will not generate a capital gains liability until the shareholder exits the investment. (To be sure, more exotic ETFs sometimes do make capital gains distributions, but as no unadorned S&P 500 ETF has made such payouts during any of the past 10 years, I stand by the generalization.)

The Game Changer: Other Taxable Assets

So far, so meh. Retail investors can pay 5 basis points each year for a broad-market ETF that distributes no capital gains, or they can pay 25 to 40 basis points for a direct-indexing program that accomplishes the same task. That is an easy call for a standalone portfolio, or for the sole taxable account of those who possess various tax-sheltered investments. Save money by joining the masses.

There is, however, an exception. If the direct-indexing assets are but one segment of a taxable account, with the other segment often producing high capital gains, then direct indexing can be a godsend. There is no way during a bull market, or even in a bear market for investments that have been held for a long time, to realize capital losses with an ETF. If the fund is sold, it will realize a profit. But within a direct-indexing portfolio, there will surely be losers to harvest.

The tax benefit is highest when direct indexing is used to offset holdings that distribute hefty short-term gains, as with hedge funds. Because such gains are treated as ordinary income, their effective tax rate can reach 50% in high-tax states. Consider a hedge fund that pays 5.0% of its assets in short-term gains, thereby creating a 2.5% IRS bill. Owning a direct-indexing portfolio that can erase that liability, rather than an ETF that cannot, is clearly the superior choice.

(Another situation that shows direct indexing to best advantage is when an investor diversifies from a profitable position in company stock.)

It may be protested that postponing taxes is not the same as eliminating them. Eventually, those securities must be sold. But that objection is not strictly correct, because those investments may be passed as a bequest, or gifted to charity, in which cases their tax benefits are preserved. Also, money possesses time value. Paying one's obligations later rather than sooner is a generally sound strategy.

In summary: Although direct indexing has merit, it is not for most. Never mind Fidelity's $5,000 minimum, which is nobly democratic but beside the point. Even the steeper hurdles erected by Schwab and Wealthfront are largely unrealistic. Direct indexing helps those who have substantial taxable assets, some of which generate ongoing capital gains. Relatively few investors meet that description.

All Apologies

Last week's column, "Have Growth Stocks Bottomed?," tentatively concluded that perhaps they had not. Boy, howdy. Since then, the Morningstar US Growth Index has dropped another 10%. To quote a country song that has yet to be written, but should, "If this is what it means to be right, Lord let me be wrong."

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.