The vast majority of active portfolio and fund managers have trouble beating the benchmarks that their funds are compared to. Whether the challenge of picking stocks is due to broad market cycles, the growth of ETFs or other factors, stock selection continues to have massive implications for investors’ financial health. In this episode of The Agent of Wealth Podcast, host Marc Bautis discusses how a direct indexing investment strategy can help create a custom portfolio, while optimizing for tax efficiency and other factors.
In this episode, you will learn:
- A history of portfolio management from individual stocks, to mutual funds, to ETF’s, to Direct Indexing.
- The benefits of implementing a direct indexing strategy.
- About tax outperformance, strategy replication, ESG screens, strategy replication and transition management.
- How to deal with low-cost basis securities in your portfolio.
- And more!
Bautis Financial: (862) 205-5000
Welcome back to the Agent of Wealth Podcast, this is your host Marc Bautis. On today’s show we are going to talk about an investment strategy called direct indexing. The financial industry is never lacking in new innovation with products and strategies. Some of them are absurd and should quickly be dismissed, but some have some merit to them.
Whenever I look at an investment strategy I look at its merits based on how it can benefit someone on the risk/return spectrum. With investing, we’re always trying to either take less risk as the benchmark we are comparing against, and achieve the same returns, or take the same risk as the benchmark and obtain a better return. We want to do all of this in the most tax efficient way possible with as low cost as possible. Direct Indexing is a strategy that can help us with these objectives.
Before I go into the details of direct indexing we’re going to take a walk down memory lane and look at some of the trends in investing.
Evolution of Portfolio Management
In the past advisors were called stockbrokers. The reason being that they sold investors individual stocks. When someone had a brokerage account they could look at a statement and usually see around 10 stocks in it. There was a lot of transparency in what they were invested in, and you and the stockbroker had control over what and when there was a change to the portfolio. But the costs were high as there was a commission of around 5% the investor paid every time a stock was bought and sold and there was no diversification. If one of the stocks had a downturn it had a IV impact on the overall portfolio value.
Along came mutual funds. A mutual fund is a wrapper on individual stocks. They are great for diversification because with one fund you could get exposure to over a 1000 individual stocks. They came with a fund manager which was an added cost, but the fund manager could decide when it was a good time to buy and sell any individual securities inside the fund. There are thousands of investors in mutual funds and the decision the fund manager makes to buy or sell something is based on whether they think it makes sense overall to do it. This would cause serious tax inefficiencies especially at the end of the year when the fund distributes its capital gains. I’ll explain how capital gains with mutual funds work. Unfortunately you could get hit two ways. First you could buy fund XYZ at $10/share. You could make a decision to sell fund XYZ sometime in the future. Let’s say at $15/share. In that case you would have $5/share of capital gains. But you control if and when the fund is sold. While you own the fund, that fund manager is buying and selling stocks that you have no control of. At the end of the year you receive a 1099 for your share of any capital gains that the fund manager accrued over the year. You had no control over this. The capital gains can be significant especially if it is a volatile year and the fund manager has to sell stocks to meet the investors demand who sell their fund shares.
To address this tax-inefficiency we saw the birth of Exchange Traded Funds (ETF’s) and the rise of passive investing. An ETF is still a basket of stocks that provides the diversification, the stocks are based off of an index that doesn’t change too frequently, thus eliminating that tax efficiency. The most popular index is the S&P 500, which contains 500 US Large cap stocks. The index doesn’t change that often, so you can avoid those large unexpected capital gains hit. I use ETF’s in my portfolio management and while they may seem simple in that you are just putting investing into these passive indexes, ETF’s can be used to generate complex strategies. On episode 31 of the podcast I talk about how I use a factor investment strategy.
With ETF’s you still don’t have control over the underlying securities in the ETF. Depending on where we are in the business cycle we could use size, quality, momentum and/or low volatility to try to optimize the risk/return strategy that we talked about earlier.
This finally brings us to direct indexing, which takes a lot of good things about ETF’s: Low cost, diversification but adds an extra layer of tax efficiency by being able to harvest tax losses and customization to the portfolio on top of it. I hear a lot of people say that they don’t like ETF’s because you get all of the stocks in the index, the good ones and the bad ones. With direct indexing you can have a strategy on how to manage the bad ones.
The Benefits of Direct Indexing
To explain how direct indexing works we’ll use the S&P 500 again, which is an index of 500 US stocks. With direct indexing you actually buy shares of all 500 companies in the index (or a subset of the 500 companies). So if you looked at your account, instead of seeing one investment in S&P 500 ETF, you would see all of the individual stocks listed. Good for transparency into knowing what you own. Now let’s look at the tax efficiency.
If you invest in the S&P 500 ETF and let’s say it has a 10% return over the year. That’s great, but if you sell it you can only sell the whole fund and would have a capital gain and owe tax.
If we looked under the covers at all of the 500 stocks, we’ll see that probably a majority of the stocks had a positive return, but there were some whose stock price went down. When you direct index, you have control and can harvest tax losses in companies whose stock price decreases. A study calculated that this tax alpha is worth 2-3% of your portfolio value every year.
You may work at Apple and not want to be over exposure risk, by having your job and company stock, and your portfolio have risk in what Apple does. You can screen out Apple from the strategy. Or let’s say you want the growth potential that stocks provide, but you don’t want to invest in the momentum stocks that are more volatile. You want to invest in some of the Quality and Low Volatility stocks to minimize your risk.
I’ve talked about ESG Investing recently and how it is one way to allow you to invest according to your values. ESG Investing is the consideration of environmental, social, and governance factors in building an investment strategy. The way ESG Investing has currently taken form is through ETF’s where the company’s included in the ETF must meet a certain minimum “ESG Rating Score.” An independent company like Morningstar generates the ESG Rating Score across a wide range of ESG criteria. But what if one criteria is more important to you than others.
By using direct indexing, you can screen out or in company’s to your portfolio in areas that are important to you like. A few examples are:
- Animal Welfare
- Abortion Providers
- Adult Entertainment
- For-Profit Healthcare
- For-Profit Prisons
- Genetic Engineering
- Global Weapons
- Nuclear Power
- Lending Practices
If you select gambling as a screen, any company that derives revenue from gambling would be excluded from your portfolio.
The ESG component of direct indexing is another way of customizing the portfolio without compromising overall portfolio goals and growth potential.
As an advisor I have different strategies that I like to employ. An example of this is the factor strategy, or a sector rotation strategy, or even a mutual fund strategy. There are some good mutual fund strategies out there. Direct indexing allows us to employ it in a tax efficient, low cost manner.
A lot of investors have existing portfolios of investments which have a very low-cost basis. Which means if we sold them there would be significant capital gains generated. They get locked into these positions. With direct indexing we can align the current portfolio allocation with the target strategy and either work around those existing positions or sell them in an optimized, tax-efficient manner.
How Does Direct Indexing Work?
I wish I could say that I was calculating and managing all of this by hand, but I have an optimization engine that helps me.
Step 1: Decompose Risk Factors
This is where we create the customized target strategy. It may be that we want to optimize against one index, a blend of different indexes. Then we can decide what filters we want to employ. ESG screens, filter in or out certain sectors, individual stocks, or themes like we want to invest in companies whose revenues are growing at a certain clip each year or are raising their dividend each year.
Step 2: Personalize the Strategy
The ASTRO engine tailors the portfolio for performance, risk, and tax efficiency around the target strategy that we created in Step 1.
Step 3: Portfolio Is Executed, Then Optimized Again When Needed
I’m a huge proponent of rebalancing, which is a strategy of maintain the target strategy someone has by periodically buying and selling securities in the portfolio. It forces you to sell high and buy low which is counterintuitive to a lot of investors behaviors.
This strategy is not necessarily new. It’s an improvement of the two strategies we talked about earlier. The stockbroker picking individual securities and the proliferation of ETF’s.
What’s allowed the direct indexing strategy to gain momentum:
- The removal of trade commissions. Late last year, Schwab announced that they were removing the $4.95 that they charged per trade. TD Ameritrade, Fidelity, and a couple other discount brokerages followed suit. $4.95 doesn’t sound like a lot, but if you’re using a direct indexing strategy with 200 securities in it, it costs $1,000 just to set it up. Now investors can get a strategy that cost them nothing. Even though the annual expense costs on ETF’s has been on a downward trajectory there is still a cost to them and depending on the size of the portfolio it can add up quickly.
- The development of the AI engine that can help take a strategy and deconstruct it to create the customized portfolio. Prior to the advance in technology a lot of these portfolios were constructed by hand, which leads to inefficiencies and errors.
I’m a subscriber to the Japanese principle called Kaizen or continuous improvement and am always looking for a way to improve and add more value. I believe Direct Indexing is a way of doing that.
If you would like to see if Direct Indexing can benefit you, I’d be happy to talk. You can call me at 862-205-5800, email me at [email protected] or set up a free consultation by going to my website bautisfinancial.com.