I think by now, most of you understand that I am a firm believer in consistent contributions to a well-diversified portfolio of low-cost ETFs.
For most, this is the easiest way to begin saving for retirement and growing their wealth.
But there is always more room for optimization, specifically on the tax front.
I saw a quote once that said something along the lines of, “Make a client $100,000 and they’ll never love you as much as the accountant who saved them $10,000 in taxes.”
Direct indexing stands to allow investors to have their cake and eat it too, but let’s talk index ETFs first.
Index ETFs are an amazing way to gain exposure to the broad market. They make things incredibly simple and are usually very cost-effective.
Index ETFs run into an issue on the tax-alpha front. When you own the index ETF, you cannot sell any of the stocks that performed poorly! Each stock is stuck in an ETF wrapper that can’t be undone.
In any given year, there will be stocks that perform well and stocks that perform poorly. 2023 comes to mind in this regard. The S&P 500 posted a whopping 24% return. This is great, but when you take a look under the hood of the S&P 500, it was not nearly as stellar a year as one might think.
The 7 largest stocks in the index, which carry the most weight in the index, were up 75%. Meaning that the rest of the index did not fare nearly as well.
Most people are not going to argue with a 24% return one way or another. But there was a missed opportunity on the tax front.
Direct indexing stands to add an additional level of alpha to the portfolio. It does this by owning each company, weighted accordingly, outright and individually.
With the help of algorithms and today’s frictionless trading world, we can now harvest losses from the companies that performed poorly, all while continuing to track the performance of the index.
The algorithm has two jobs:
Track the index: This is the primary goal. You can usually adjust your tolerance to tracking error when direct indexing. Ultimately, you want to follow the index, but allowing for additional tracking error will allow for more aggressive loss harvesting.
Harvest losses: It is important to know that this is the algorithm's secondary goal. It has to constantly weigh the pros and cons of selling a position. The larger the weighting of the position, the less likely a loss would be harvested, as this would put a major imbalance in the tracking of the portfolio to the index.
To me, this is one of the most incredible pieces of financial engineering I have ever seen. People have always slept on the benefits of taxable brokerage accounts, as usually Roth IRAs and 401(k)s take the cake.
Now, there is actually an argument that direct indexing could be seen as a type of synthetic Roth IRA.
Why is this idea of tax-loss harvesting so game-changing?
Capital losses can be carried forward indefinitely
Capital losses can be used against capital gains
Up to $3,000 in capital losses can be used against ordinary income each year.
When our index ETF user went through 2023, they were happy about their returns. Our direct indexer got more or less the same returns as the ETF user, but they now get to use $3,000 in capital losses against ordinary income and carry forward any additional losses to net their gains even when it comes time to sell.
If someone had a 30% effective tax rate, the $3,000 deduction is saving them $900. Capital gains are taxed at 0%, 15%, or 20%. Down the road, the direct indexer can use their capital losses to net their gains, even and (hopefully) effectively pay zero taxes on their gain.
One example of direct indexing that I was able to see tracked the Nasdaq 100 index. In 2023, this index gained 55.13%. The direct indexing platform that tracked this index gained 55.11%.
The difference? On a $1,000,000 portfolio, the direct indexing strategy realized over $49,000 in losses.
Direct indexing is not new. It has been around for a while. Today’s technology and frictionless trading environment have this strategy poised to take off in the coming years. The potential to attain market returns while also capitalizing on losses over the course of the year poses such an incredible opportunity for investors.