Direct indexing is getting Wall Street’s attention
Tax awareness continues to grow.
My good friend, Hardika Singh, of Fundstrat reached out to me earlier this week and sent me a WSJ article. The article, which is linked here, covers direct indexing and this somewhat new form of tax-aware strategy that is being rolled out.
First off, I wanted to refresh everyone on direct indexing. I’ve shared about it previously here but let’s refresh:
Direct indexing is a way to invest in a specific index at an individual level. So, rather than buying an ETF that tracks something like the S&P 500, an investor could “direct index” and own the index through purchasing shares of each company individually.
Technology plays a huge part of this. Imagine buying 500 stocks individually and weighting them accordingly?! Madness. But with today’s tech, it can be as easy as pressing a few buttons and the index is then broken out by individual holdings.
At face value, it seems nuts. Why would anyone want to add that level of complexity to their investments?
Sometimes the benefit is customization, but more often than not, the real driver is taxes.
Caveat: Yes, direct indexing can offer significant amounts of customization. It offers the ability to remove any single issue from the portfolio. This is huge for a lot of ESG investors and those who are paid in company stock.
On any given day, the performance for most indices is based on the weighted performance of the companies that make up the index. But, on any given day, some stocks are down.
Direct indexing allows investors to capture those losses on a frequent basis. Some company had a bad day? Well, the direct index investor can capture that loss. The ETF investor cannot.
As crazy as it may sound, capital losses have economic value. Realized losses are first used to offset realized gains. From there, up to $3,000 can be used to offset ordinary income. Anything remaining from there can be carried forward indefinitely (at the federal level).
This can be a pretty tax-savvy move for some investors. Short-term capital gains are taxed at the same rate as ordinary income. Long-term capital gains are taxed at 0%, 15%, or 20%.
Having a loss that an investor otherwise wouldn’t have had can be incredibly advantageous. But there are potential drawbacks.
One of those drawbacks is tracking error. The second something is sold in the direct index, it is no longer tracking exactly as the index would be. Usually, a direct index will wait 30-days before buying those shares back to avoid a wash-sale.
So, for 30-days, the direct index no longer holds those shares. This can lead to the direct index deviating from its underlying index’s performance.
One thing I will note: “tracking error” is just a deviation in performance between the index and the direct index.
Most understand this but believe it to be outright bad. I think that stems from the word “error”. However, tracking error can be negative or positive.
Imagine this scenario: A direct indexing software wants to sell a stock to realize a loss. The investor owned the shares at $100 and sold them at $80.
They captured a $20 loss. Then the shares fell further to $50. The direct index “saved” the investor from another decrease in share price!
While this is possible, with the market performing well, it is usually the other way around. Over extended periods of time, the amount of losses to realize may dissipate without the addition of fresh capital.
It makes sense, right? Markets generally appreciate, if we don’t add fresh capital (resetting our basis higher), the direct index will eventually lose steam and be unable to find losses to harvest.
Well, the WSJ article brought attention to a new way to exacerbate losses. I’ve been familiar with this strategy for a little while and the TPCP® coursework even covered this strategy as well!
Add some leverage. The next iteration of tax awareness brings leverage into the picture.
The WSJ article does an amazing job highlighting the mechanics, but I’ll quickly go through it here.
Imagine someone has a $1,000,000 portfolio. Through the use of leverage and short selling, the strategy can add $300,000 of short exposure and $300,000 of long exposure.
Essentially, they short $300,000 and add more to their longs with the other $300,000.
We now have a 130/30 long-short portfolio. 130% of the portfolio is long and 30% of the portfolio is short. The net market exposure remains close to 100% as the leveraged extensions cancel each other out, but this strategy is complex and can introduce additional risks.
The point of this is to constantly have losses to harvest. If stocks move up, the short will lose which can exacerbate the losses.
This strategy is very niche and there can be risks involved whenever leverage enters the picture. Nonetheless, I think it is a great example of how much value some high-net worth investors are placing in tax-awareness.
This is for informational purposes only and is not intended as legal, tax, or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of publication and are subject to change without notice. Past performance is not indicative of future results.