investing
Investors who want control over which stocks they own are looking at direct investing. It comes with some distinct advantages, but it’s not for everyone. Here’s what to consider if you’re curious.You may have heard about direct indexing recently. It isn’t new, but it may feel that way given all the attention and interest it is generating these days. The elimination of trading commissions has been a major factor in making direct indexing significantly more accessible. A strategy that was once relevant only to very wealthy investors is now something that almost any investor can consider. But is it right for you?
To help answer that, I put together a primer covering some of the basics – what direct indexing is and how it works, the primary benefits it is designed to offer, and some things to consider if you’re curious about learning more.
What is direct indexing?It’s pretty simple, really. Direct indexing – which we call “personalized indexing” at Schwab – means you own the stocks (or a subset of stocks) that make up an index directly. This differs from traditional index mutual fund and ETF investing where you own shares in the fund (alongside many other shareholders), but it’s the fund that owns the stocks. The price of your shares therefore rises and falls with the stocks in the index, but you don’t actually own the underlying stocks themselves. Your exposure to them is indirect.
Ownership matters because it allows you to customize the stocks held in your account. At one time that would have been very expensive to do because trading came with commission costs, and you had to buy stocks in increments of whole shares. Not anymore. With the large-scale elimination of commissions, direct indexing suddenly emerged as a viable strategy for investors of all kinds.
That said, it’s not for everyone.
BenefitsDirect indexing allows you to personalize your investing approach. There are a number of potential features associated with that, but for the sake of simplicity I’m going to focus on the two primary benefits:
Tax efficiencyIt may sound counterintuitive but stocks with losses can represent an opportunity to help a portfolio. When you sell a stock that has gone down in value, the tax code allows you to use that capital loss to offset capital gains that come when you sell another stock that has gone up in value. It can either be done right away or banked for future use. It’s called “tax-loss harvesting,” and it spans more than just stocks – it can be applied to different securities, such as bonds, and different investment products, such as mutual funds and ETFs. So as markets fluctuate, opportunities emerge to create losses that can be offset with taxable gains, thereby lowering your tax liabilities over time.
Direct indexing allows you to make tax-loss harvesting systematic – banking losses for use against future gains – while staying invested in the market. Active tax management also provides the potential to outperform the index on an after-tax basis – a potential benefit sometimes referred to as “tax alpha.”
CustomizationMost direct indexing offerings begin with access to some core indexes, such as the S&P 500 or Schwab 1000. From there you have the option to personalize the portfolio by excluding certain companies in it. Those decisions could be driven by personal values and beliefs, such as excluding fossil fuel producers, gun manufacturers, alcohol and tobacco companies or other stocks.
Customization can also be used to balance out an overconcentration elsewhere in your portfolio – for example if you own stock in the company you’re employed by, or you already have positions in a company and prefer not to take on more. The bottom line is that the level of transparency into each holding offered by direct indexing can create more opportunity to personalize investments.
There are other potential benefits such as the flexibility to give your portfolio customized tilts toward certain styles such as value or momentum, and even do charitable giving through the donation of handpicked appreciated securities. But the place to start for most investors who are thinking about direct indexing is to consider what the tax efficiency and customization upsides are worth given your own individual circumstances and preferences.
Is direct indexing right for you?While direct indexing solutions have come way down in price, they’re not free. So, any benefits have to be weighed against the costs to buy in. By way of example, Schwab offers a solution at a fee of 0.40%.
With that in mind, those most inclined toward direct indexing solutions tend to fall into the following categories:
Investors with sizable taxable accounts and in higher tax brackets who may benefit most from tax-loss harvesting;Investors who wish to better align their portfolios with their personal values in a customized way rather than through pre-packaged ESG products; andInvestors with concentrated positions in one or more stocks who are seeking a customized way to bring their portfolios into better balance.If you fall into one of those categories, take a closer look and do your due diligence, as there are nuances between the many offerings currently on the market. Fees vary of course. Consider also what’s an appropriate investment minimum for you to fully benefit from tax-loss harvesting benefits. Also explore whether the offering is fully automated or comes with the help of a human adviser.
Direct indexing may not be for investors with smaller accounts, in lower tax brackets or with assets primarily in tax-deferred accounts because they wouldn’t benefit as much from tax-loss harvesting opportunities. The same can be said for investors who don’t have individualized circumstances or points of view that would benefit from the ability to customize their portfolios in a personal way. In both cases, those investors may be better suited to an index mutual fund or ETF. For a more sophisticated product like direct indexing, human help can be invaluable, so speak with your financial consultant or registered investment adviser.
The last thing I’d say is even if you decide direct indexing isn’t for you, continue to watch the trend toward greater personalization as it grows and evolves. In some of the same ways that our experiences have become so individualized in other parts of our lives – when we’re driving, shopping, using our phones and more – the same is happening in our financial lives, and more is coming.
Disclosures: Neither the tax-loss harvesting strategy nor any discussion herein is intended as tax advice, and Schwab Asset Management does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks, including unintended tax implications. Investors should consult with their tax advisers and refer to Internal Revenue Service at www.irs.gov about the consequences. Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.Please refer to the Charles Schwab Investment Management Inc. Disclosure Brochure for additional information. Portfolio Management for Schwab Personalized Indexing is provided by Charles Schwab Investment Management Inc., dba Schwab Asset Management, a registered investment adviser and an affiliate of Charles Schwab & Co. Inc. Both Schwab Asset Management and Schwab are separate entities and subsidiaries of The Charles Schwab Corp. 0722-28AMThis article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Amy Richardson, CFP®Schwab Intelligent Portfolios Specialist, Charles Schwab
Amy Richardson is a CERTIFIED FINANCIAL PLANNER™ professional and Schwab Intelligent Portfolios Specialist. Amy focuses on providing internal teams, clients and prospects with education, updates and information about Schwab’s investment offerings and philosophy, including Schwab Intelligent Portfolios (Schwab’s automated investing service) and Schwab Intelligent Portfolios Premium (combining automated investing with a comprehensive financial plan and unlimited guidance from a CFP® professional).