Once an obscure investment strategy used only by the ultra-high net worth, in recent years direct indexes have emerged as a way for mass market investors to tap into what they call an “all-your-own” stock portfolio. .
The idea is that investors don’t have to settle for off-the-shelf or exchange-traded funds. Instead, she can customize her things according to her own values (no oil drilling company, for example). Along the way, she can also derive additional profits from tax strategies that focus on screening losing bets to offset the profits of winning bets.
But it’s not the lure of personalized security selection that drives investors directly to indices today. Increasingly Available to Main Street Investorsinstead, it’s a trending tax benefit, a new Morningstar report reveals.
“Tax management is the biggest reason Investors look directly at the index. Personalization is his second most popular reason,” the report said. Let’s take a look at the options and opportunities for investors,” it said Thursday.
The Direct Index, which Morningstar said had $260 billion in assets at the end of last year, has two characteristics. One approach is to take an existing benchmark, such as the S&P 500 Index or the Russell 3000, buy a proportionate amount of that stock, and hold it in a taxable brokerage account.
A more bespoke approach involves creating your own index. For example, create an index of companies that have approved the most shareholder proposals and buy shares in them. For example, investing in environmental, social, and governance “could mean just about anything,” says Morningstar, but using a direct index would allow “an investor to make his ESG investments You can focus on the most important aspects of
Why not buy mutual funds or exchange-traded funds that track a particular index, especially since many ETFs also deploy similar tax tricks?
Owning those funds does not allow investors to actively engage in harvesting tax losses and fine-tuning profits. This strategy involves an investor intentionally selling a diminished position, recognizing losses for tax purposes, and using those losses to offset the tax liability of other positions, including assets held outside the portfolio. including offsetting the capital gains of
According to Morningstar, investors can earn an additional 1% to 2% annual return, with wealthy investors in the top 37% of tax rates enjoying the biggest gains.
Not all tax loss harvests are the same
An additional boost is due to allowing investors to use realized losses. This means losses are actually taken, not on paper, and can be offset with an unlimited amount of realized capital gains per dollar. Unused losses can be carried forward indefinitely, similarly reducing taxes on investment profits. Investors can use it to offset losses of up to $3,000 if there are not enough profits to absorb the losses in a given year. This means you can reduce the taxes levied on your regular income, such as your salary.
Even if the ETF’s manager recovers the fund’s losses, the move will not affect the investor’s cost base, or the fund’s original purchase price, a key factor in determining the taxes investors must pay when the fund is sold. No. Instead, the tax benefits of this move come from the fact that the fund does not waive taxable capital gains distributions like mutual funds do.
In contrast, an investor recovering losses in a direct index portfolio gains the ultimate income tax benefits directly.
The S&P 500 is up more than 7% so far this year. But 83% of that profit comes from just seven stocks: Apple, Microsoft, Nvidia, Tesla, Meta (Facebook), Alphabet (Google) and Amazon, said executive director of wealth solutions at Abidian Wealth Solutions in Houston. says Scott Bishop.
If you own an ETF that tracks that 500-stock benchmark, you can’t recover individual losses from hundreds of stocks. But if you own the equivalent through a direct index portfolio, “you can go down that road,” Bishop said. “For large investors who have after-tax money, it’s actually very tax-saving.”
Other key takeaways from Morningstar’s research:
“Direct Index Arms Race”
“As direct indexes have grown in popularity, we have seen a wave of acquisitions by the largest asset managers.” Vanguard acquired Just Invest in late 2021 and launched a direct index service. This was Vanguard’s first acquisition in his 47-year history. The unit, now called Vanguard Personalized Indexing Management, marks the fund giant’s ambitious plans to expand in a niche.
Other Recent Direct Index Acquisitions by Wealth Management Firms: JP Morgan acquired tax-focused financial technology firm 55ip at the end of 2020. Morgan Stanley acquired Eaton Vance and its subsidiary Parametric Portfolio Associates in his 2021. That year, BlackRock acquired his second largest direct indexer, his Aperio.
“Other companies are building their own products or forming strategic partnerships. For example, Charles Schwab will build an index service directly on its brokerage platform in 2022, with both Natixis Investment Managers and Principal Asset Management worked with smaller companies to create the service.”
read more: Fidelity Brings DIY Direct Indexing to Investors
commission
Fees for directing index investments are generally higher than those for mutual funds and ETFs. A study conducted by Morningstar of some of the largest direct index providers (which did not disclose the names of the companies) found that the surveyed providers had an initial cost of 0.25% of the minimum investment of $250,000. to 0.40% for companies targeting smaller accounts.
Fees for most US Large Cap Indices start in the 0.20% to 0.40% range and decrease as your account balance grows. Schwab drops its fees from 0.40% to 0.35% when an account exceeds $2 million. Fees are generally higher for international or highly specialized niche indices.
Taxes and the “secret sauce”
According to Morningstar, most direct index providers have published research showing that investors can expect an additional 1-2 percent annual return from using tax loss harvesting. “There is always a loss somewhere,” he writes.
It is a controversial area.
“Direct index clients typically expect tax loss harvesting, but there are endless ways to determine what types of losses are worth harvesting,” the report said. I’m here. “Is it a decrease of 1%, 5%, 10%, or more? Direct indexers tend to run their tax management algorithms daily, but you can set any threshold to lock in losses None of the direct indexers surveyed shared their tax losses.Some, like BlackRock’s Aperio, leave the choice to investors.You’ll want to recover every penny of your losses. However, it can lead to increased trading volumes, leading to increased tracking errors and potential trade impact costs.”
read more: Sell stocks for tax cuts?Beware of These Tripwires, According to New Paper
read more: Who benefits from direct index tax benefits? Probably not you
read more: With tax loss harvesting, you reap what you sow
read more: The Dangerous Aspects of Tax Loss Harvesting Advisors Should Know
A phenomenon called tracking error occurs due to the wash sale rule when investors sell losers to reap losses. According to these rules, an investor must, before or after the sale of a security, to buy back the same security, or purchase a “substantially identical” security if he wishes to claim a capital loss, 30 It is said that you have to wait for days.
Morningstar says, “Investors need to pay close attention to direct index tracking error.”