Direct Indexing

Transcript

Whitney Reagan: What if we told you there’s a portfolio strategy that could lower your tax bill, allows customization and diversification? What more could you want?

Welcome, welcome, thanks for joining us. This is another episode of Your Life Simplified. I’m Whitney, wealth advisor at Mariner, and I am super excited to be joined by Dan, Senior Wealth Advisor and Certified Financial Planner, also a colleague and co-host of mine. How are you doing today, Dan?

Daniel Sharkey: I’m great. How are you?

Whitney: I’m terrific.

Dan: It’s always great to be here. This is the first one that we’ve done together in a while. We’ve had guests in the past, but now it’s just the two of us.

Whitney: So, I know we’re really excited to get into the topic, it was your idea, but I thought maybe how we could start this episode maybe with a lightning round.

Dan: Hit me.

Whitney: Or maybe just a fun question to get us a little warmed up. Are you reading any good books right now?

Dan: So, I am. I just finished a book called The Republic of Pirates, which traces — and this is exciting stuff for our listeners — which traces pirate history in the Caribbean. So for us East Coasters, that is our vacation spot of choice when we’re looking to get away to the beach. So, my kids have been super interested. I think this is primarily driven by Disney World and the Pirates of the Caribbean, but that’s something that we’ve been reading about recently. So, for any of those interested, The Republic of Pirates, highly recommended from the Sharkey house.

Whitney: Well, that sounds a lot more interesting than the book I’m reading. It’s No Drama Discipline. It’s more about parenting and disciplining because just having some constant trouble with my kids.

Dan: Here’s another candy bar and just please go in the other room. That’s the solution that we reach over here sometimes.

Whitney: That’s right. Okay, so let’s start nerding out on the topic at hand, and it’s called direct indexing, but I feel like it’s so much more interesting than that.

Dan: So, it’s my favorite thing to talk about, and I hope everyone who’s listening really takes what we’re saying to heart in terms of how they could potentially implement this and why they should implement it. But we’re here to talk about direct indexing, and we’ll get into exactly what that is, why you should be doing it, how we do it here. But that is really what the focus is today, and we’re happy to kind of dive into those details.

Whitney: That is correct, and in the intro we kind of talked about all of the benefits of direct indexing, but I think we should really start with kind of a foundational layer here and just start with the basics. So Dan, can you tell us, what is direct indexing?

Dan: Sure. So it sounds like a very heady name, but it’s really as simple as you can possibly get. So before we kind of get into what that is, let’s just set the table on what has traditionally been available to investors — over time, things like the mutual fund and most commonly the index fund or ETF, which are relatively speaking, more recent innovations. As an individual investor, you are able to get broad market exposure by owning a single fund. For the sake of this conversation, I’ll use the S&P 500 for example. You can go online at any of your custodians or any of your brokerage houses and purchase very, very small quantities of an S&P 500 index fund and get the exposure of the entire market. These products have a huge benefit. You need very little capital to get exposure to them. It’s a one-stop shop for getting immediate portfolio diversification, keeps trading costs down, etc., etc. So it’s a wonderful innovation.

What direct indexing is, it’s taking that innovation, being able to give you broad market exposure, and taking it to a whole new level. It’s like indexing on steroids. And what direct indexing really is, it allows you to create — again, going back to the S&P 500 as our baseline example — it allows you to create that individual index but use the individual securities in your portfolio directly. So, as opposed to using an individual ticker symbol, let’s say SPY is one of the most common examples for the S&P 500, you would actually own a basket of securities that comes close to replicating the 500 securities that are in the S&P 500.

Whitney: And let’s dig a little bit more into the access to the individual securities. So, a lot of times, maybe, our listeners have heard of a separately managed account. When you’re opening a separately managed account and you’re owning these securities, that is different than accessing a mutual fund or an ETF because those are kind of owning a sliver of the product, rather than the individual — actual individual ownership of the stocks. So, can you talk about what’s the benefit of that versus the other or the alternative of, like, an ETF or mutual fund?

Dan: It’s a great question, and it partially explains what the benefits of the mutual fund or ETF are and then why you would want to potentially take this other approach. So, the benefit of the ETF is that my money, your money, everyone else who’s listening, owns a proportion of this index, right? So you have very little capital that you need to get involved. Here, when you own the individual pieces, that really means that you get to customize your exposure and materially benefit from any type of performance that those securities have during the course of your investment.

So, let me just give you a quick math example to highlight why this is so important. So, for example, in 2023, and I have the numbers right here, it was a great year for the S&P 500. The index was up 26.3%. Of the 500 names that are in that index, 171 of them were actually negative for the year. So, think about that, that equates to about 34%. So, if you own the index, you get the 26.3%. That’s a great return, right? But you’re unable to benefit from any of those securities that are in the negative for the year. When you take a direct indexing approach, when you own those individual securities, you can use those losses that are generated throughout the course of the year to directly impact your tax return. It’s called tax loss harvesting. It’s a great way to make sure that you can stay hyper efficient without — and this is the key — without materially giving up any individual performance. Essentially, you are using the ingredients of the dish to create yourself an index at home without having to utilize a pooled product like an ETF or a mutual fund.

Whitney: I also like to give the example of the S&P 500 index since there’s 500 stocks in that, 500 securities in that index. If you’re doing a direct indexing strategy, typically, just to make it simple, you could purchase 250 of the 500 stocks. And that way you have half of those securities that you’re not owning that you could use when you’re tax loss harvesting and selling out of a position and then buying another one. Am I thinking about this correctly?

Dan: You’re thinking about it 100% right, and which is why this is so difficult to actually do at home, if not impossible. And we’ll talk more about that here in a second, but you actually don’t even need to own all 500. If you look at the composition of an index, like the S&P, for example, there are dozens of securities that have such a small weight in the index, meaning the amount that they comprise of the total is really minute. Meaning if they’re up or down by significant sums, it really doesn’t impact the overall performance. Things like NVIDIA and Apple and these other securities that have a larger market capitalization or weight, the percentage of the index that they occupy really drive a lot of the overlying performance. So, to your point, you don’t even need to own all 500. You can own a percentage while still maintaining, tracking the performance and still getting the after-tax benefits.

Simply put, and I don’t say this lightly, this is for a taxable account, all tax deferred accounts, what I’m saying doesn’t really matter because there’s no tax consequences on an annual basis. For taxable accounts, this is a better solution than using those pooled products, provided that you have the right amount of capital to do this. It’s one of the best financial engineering innovations of the last 30 years, I know for my client portfolios and for yours as well. We urge clients to take this approach because of the material after-tax benefits of doing so, and we haven’t even gotten into the customization of that, which we’ll talk about here shortly. But it’s a huge benefit, and it’s a better way to get that stock exposure that we have in nearly all of our portfolios.

Whitney: Great points, Dan. And I do want to, because direct indexing has kind of been a buzzword and it’s been more attractive and more popular in recent years, but there’s also a lot of words that kind of get thrown around when you’re talking about direct indexing. And I love in our podcast here, we try and simplify things and hopefully re-educate the audience on what these topics are. So, a lot of times if you’re reading articles, if you hear from maybe a financial advisor, something like “tax alpha,” or if you can get tax alpha out of this strategy, what does that mean?

Dan: So, it’s a great question, and we shoot ourselves in the foot by talking all this jargon nonsense half the time. Tax alpha is precisely what we want to address, but let’s think about it in very basic terms. So, alpha just means the amount of extra performance you get relative to a benchmark. If the benchmark does 5% and your portfolio did 5.5%, you did 0.5% of alpha — out-performance across a benchmark. So what tax alpha is saying is, how much less tax did you ultimately end up paying by managing your portfolio in a very tax efficient way, and how much did that add to your total performance?

So, for example, if you save, let’s say, $20,000 in taxes by taking this strategy and that equates to approximately 1% of the total portfolio, you had 1% of tax alpha. Your portfolio is 1% better because you actively managed your tax exposures appropriately. And that’s the beauty of this strategy. You don’t have to make what we call active bets. You don’t have to guess whether going to outperform Amazon or NVIDIA is going to outperform Broadcom, or whatever the comparison that you want to use. Just by being mindful of what your exposures are, allowing us to trade the portfolio in a tax efficient way, creates this automatic tax performance. I don’t want to say automatic in the sense that happens every year, but this after-tax benefit that you receive is very, very real, and in some years in which there’s more volatility, can be really, really significant. So it’s something that has to be looked at closely and see if it’s appropriate, but we use this quite often in our client portfolios.

Whitney: Okay, and another term that I think is important to maybe define is tracking error because a lot of times when we’re talking about this direct indexing strategy, you are trying to replicate an index and have the lowest tracking error possible while generating returns and actively tax loss harvesting. So, maybe you can explain in simple terms what that would mean.

Dan: Absolutely. So tracking error is an underlying principle that makes this strategy kind of tick. And all tracking error is, very simply, is the deviation from a return that your portfolio has versus a benchmark.

So, again going back to the S&P 500, if I have, to use a very kind of dramatic example, if I have a portfolio of two stocks, Apple and Amazon, and I’m going to compare that to the S&P 500, the tracking error, the difference between the performance of those two pools of capital is going to be fairly wide. Meaning that the Apple and Amazon may do better, may do worse, but it’s most likely going to materially differ from what the basket of securities that comprise the S&P 500. So it’s that difference in performance from those two pools of capital. So what this strategy does is that it closes that gap. It means that you’re likely to track or follow the performance of the index in question much more closely than you would if you had a smaller composition of stocks that are materially different than the composition of the index. So tracking error is simply the difference in performance of two different pools of money, depending upon what those pools are comprised of.

Whitney: Okay, thank you for that answer. I think tracking error is also a way to measure how actively you’re managing the portfolio too. So, we’ve talked a little bit about the tax benefits of a direct indexing strategy and really actively harvesting those losses to offset gains. So, hopefully you’re lowering your tax bill.

Dan: Exactly.

Whitney: Let’s talk a little bit more about some of the other benefits which we’ve mentioned before, customization, I think, and diversification. So maybe we just touch on the customization piece.

Dan: Yeah, so customization is another huge benefit of taking this type approach where you’re using the individual stocks as opposed to the index.

So, let’s give a clear example. Let’s say that you’re a tech worker, right? You work for Google, Meta, any of the other large tech companies, and a lot of your compensation is tied to the success of the tech sector. Well, for any of your outside assets, you may determine that I don’t really want more tech exposure, I already get that through work. Well, you can customize what goes into a direct indexing program to include or exclude any of the sectors, individual companies, or anything else that you may find objectionable or that you don’t want to have more of. So you can say, “I want to exclude technology,” and we can build the index that would replicate the exact exposure, less the technology piece.

Another clear evidence would be if people have certain values that they want to represent in their portfolio. There’s a never-ending list of things that are important to each person. We don’t claim to know what those are right for you, but we make sure that we ask the question so that people can customize their exposures as needed, and you can exclude those securities as well. So the level of customization and freedom that you have to determine what goes in your portfolio when you take this type of approach is basically endless. When you buy the S&P 500 Index Fund, you’re going to get whatever’s in that index at that time, regardless of how you may feel about the underlying companies.

Whitney: And also along the customization piece, I think it’s really valuable when we have clients that maybe have some specific religious beliefs where they actually have to exclude certain things or certain sectors within their investment portfolios. So we’re able to use direct indexing in that way to accomplish those goals.

Dan: Absolutely. So, whatever your need is to include or exclude something, that is precisely why the strategy exists. So the beauty about working for a company like Mariner is that we have this open architecture in which we can implement a variety of different things to fit the end user. So, it’s not up to us to determine what you should or should not have, but we’re going to make sure that we understand what that is. So for those that do have religious concerns or just know that I can’t have certain things in my portfolio, this is the perfect solution to make sure those are excluded and make sure that we don’t ever cross those wires where people end up with something that they’re just not comfortable with.

Whitney: Okay, so we’ve talked about the tax benefits or the tax efficiency of this type of strategy, the customization, and being able to invest alongside your values, or being able to invest by excluding certain companies or sectors or industries that maybe you already own a lot of, so you don’t want to be over-concentrated in that type of allocation.

Now, we’ve already kind of touched on diversification, but do you want to maybe touch on more benefits of how this is able to help with diversification?

Dan: Yeah, exactly. So, one key example that I’ll give you is that if you have a highly appreciated, let’s say concentrated stock that you maybe not want to divest from. Well, we can build the portfolio around that position using other securities to provide that level of diversification without having to sell that individual stock, which is how a lot of clients come to us anyway. With this type of approach, since you’re utilizing the individual pieces, again, the level of customization is basically endless. So, you have that ability to work with what you have now, work with the embedded gains that may or may not be in your portfolio, and still provide that kind of well-rounded approach overall.

It’s not without some downside. The most glaring example would be, you need to have a large enough capital base to be able to do this, right? You can’t replicate an index of let’s say 300 or 400 securities with $5,000, and that’s why those ETFs and index funds are great for those smaller clients. However, if as your taxable side begins to grow and grow and your level of customization may increase, you may need more diversification than you have right now. This is, quite simply put, just a better after-tax solution.

The other thing that I’ll mention is that we can actually measure it. I think what you were alluding to before is when we implement this for current clients, talking about tax alpha, we can come up with a number that you can basically highlight to someone and say, “Look, this is how much better off you are by taking this type of approach. Furthermore, any losses that you generate that you may not use in a calendar year, they stay on your tax return.”

So I have clients right now that, for example, have sold vacation homes. If they have a capital gain and any other financial asset that they may own, you can use these on your return to offset those gains as well. So, the benefits don’t expire, they stay on your return, they help you with either the current portfolio or other capital assets in your financial life that you may have to pay tax on. So, don’t worry about if you don’t use them in any given year. The benefits are basically endless in terms of carrying forward. They’re called carry-forward losses for all our tax brethren out there who work with this stuff daily. So, that’s an important consideration too. Just because you generated in 2024 doesn’t mean that you have to use it in 2024.

Whitney: Okay, Dan, I can see that the joy and the passion just kind of emanating from your body here. I know that this is a really terrific strategy, and we’ve talked about all the benefits, but what are some of the cons or some of maybe, I don’t know if there’s really cons, but why wouldn’t you want to use this?

Dan: Two things kind of pop up to my mind. One is that if you have any restrictions through work about owning individual securities. Meaning that, I have some clients who work for the federal government, for example, and they can’t own certain stocks in the banking sector, for example. So, in order to never cross wires or put them in a position through their employer, we decided that hey, owning mutual funds is just as good because that way we’re not going to run into any compliance issues.

Whitney: We do also have, just touching on that point, we also have, I’ve experienced this with clients that work at the Fed. They have a lot of blackout periods, and so working around those blackout periods all throughout the year is just — it’s way too complex to navigate those dates with this type of strategy in how systematic the portfolio management is.

Dan: Exactly. So, great minds think alike, because the client that I was referring to also works at the Fed, and that’s just a bright line that he cannot cross. So therefore, it’s just not something that we’re ever going to really touch on.

The other thing is that sometimes people don’t want — when you open your brokerage account, you’re going to see all the positions. Now at Mariner, when we show you our customized reporting, we basically roll all those positions up so it’s not as onerous, but you’re going to see four, five, six, 700 positions, depending on how big your portfolio is. And some people just don’t want to look at that administratively. Those are really the only major downsides that I see.

I’ll throw one more at you that I think is worthy of people understanding. This is nearly impossible — I don’t want to say totally impossible because I’m sure we have some very creative folks out there — but this is nearly impossible to do on your own. The amount of active trading that you would have to do, the technology that you would need, the potential trading costs that you would have to absorb, is usually far too much for any individual investor to do. This takes bandwidth, it takes people, it takes technology, it takes a platform, it takes underlying analytics to make sure that your exposures are actually correct. So, this is really not something that you can do on your own, yet the popularity of it has grown so high that it’s available, certainly here and at most other places as well. So it’s really important to be able to figure out if it would apply to you and if you could benefit from it, but it is very difficult to do as a DIY investor at home.

Whitney: Well, and the most efficient types of portfolio managers are using some kind of optimization software and not having to go in and specifically trade as manually as you would think.

Dan: Exactly —

Whitney: And what —

Dan: I’m sorry, go ahead.

Whitney: No, that’s okay. What about the fees? I wanted to touch on that just in case people are wondering, is this really expensive to do, outside of having to have a certain amount of capital?

Dan: For those who are listening, you can’t see the glee and smile on my face right now, but hopefully you can hear it coming through my voice. And that is, this solution is particularly inexpensive, which is another reason it is just so wonderful to be able to use when the circumstances are correct. You don’t have what we call an active bet, meaning we’re not deciding if NVIDIA is going to outperform Broadcom. We are simply giving you the market exposure but giving you the foundational pieces, so that can be done rather cheaply. We’re talking 10 basis points or less, compared to an actively managed fund, which may be over a percent or more. I mean, materially, materially cheaper. Is it slightly more expensive than an ETF? Probably, but you’re talking in single digit basis points, which is 0.01%. So it’s an inconsequential difference.

I would also submit that the after-tax benefit of absorbing that extra five or six basis points of cost is an exponential multitude of what you would pay in extra fees. So the fees are inconsequential as far as I’m concerned, from a wealth creation standpoint. And the fact that this strategy is so cheap to implement through the right advisor makes all the difference in the world.

Whitney: So, Dan, a lot of great talking points that you’ve included here. And just to summarize, I want to say, the direct indexing strategy is a very valuable tool. And there are a lot of different benefits that go along with direct indexing, including potential significant tax benefits. It also allows a lot of customization, whether it’s alongside your values or what your beliefs are, or in the scenario of having a concentrated stock position and needing to exclude specific securities or sectors or industries. And then it also has the diversification benefits because you’re getting broad access to a specific index or type of market. And so I think all of these are terrific points to talk about. Are there any other takeaways that we need to include?

Dan: No, I mean, I think one thing I would say is don’t be intimidated by the fancy language and tax alpha and the jargon. This is simply just a better mousetrap of a very common idea. As opposed to buying a fund, you are simply replicating that fund but using the ingredients of the soup directly. That’s the biggest takeaway. On paper, it’s a very simple thing and if you care about how much you pay in taxes and what the exposures are that you’re getting, this is just a better mousetrap. It’s one of the best innovations and you should really consider if it would be applicable in your portfolio and in your financial life, because we think that the benefits are tremendous.

Whitney: And if you have any questions or if you wanted to talk more about this, we encourage you to find a financial advisor if you don’t have one already. Definitely always be curious and ask questions to your financial advisor if you have one.

So thanks, Dan. I always love chatting with you, having this type of fireside chat. And thank you to the audience for joining us and listening in. We hope to have you around for future episodes. If you liked what you heard today and you want to hear more industry insights from either Dan or myself, please like, subscribe or follow wherever you listen to your podcasts. And we hope you have a terrific rest of your week.

The views expressed in this podcast are for informational and educational purposes only, and do not consider any individual personal, financial, legal, or tax situation. As such, the information contained herein intended and should not be construed as a specific recommendation, individualized tax, legal, or investment advice. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals regarding their specific circumstances and needs prior to taking any action based upon this information.

The information provided has been obtained from sources deemed reliable. However, the accuracy, completeness, and reliability cannot be guaranteed. Tax laws are subject to change, either prospectively or retroactively. Any opinions expressed are subject to change at any time without notice. There is no assurance that any investment plan or strategy will be successful. Investing involves risk, including the possible loss of principle. Past performance is no guarantee of future results, and any opinion expressed herein should not be viewed as an indicator of future performance.

Mariner is the marketing name for the financial services businesses of Mariner Wealth Advisors, LLC and its subsidiaries. Investment advisory services are provided through the brands Mariner Wealth, Mariner Independent, Mariner Institutional, Mariner Ultra, and Mariner Workplace, each of which is a business name of the registered investment advisory entities of Mariner. For additional information about each of the registered investment advisory entities of Mariner, including fees and services, please contact Mariner or refer to each entity’s Form ADV Part 2A, which is available on the Investment Adviser Public Disclosure website. Registration of an investment adviser does not imply a certain level of skill or training.

All Categories

Recommended insights