The investing trend known as direct indexing promises two things: the ability to craft a retirement portfolio as custom as a BMW X7 with surround sound, and tax benefits.
Only one of those two pledges is certain, however. As the strategy that was long available only to the ultrawealthy makes its way into Main Street, it may leave some ordinary investors disappointed.
Direct indexing consists of buying some or all of the underlying stocks of an established index, like the S&P 500, or creating an “index” that reflects an investor’s personal values — large-cap companies, but excluding something like oil or mining names. The ability to create a bespoke benchmark to mirror — the custom part — is framed by wealth management firms as a simple way to buy only what you love and believe in. There’s no barrier to anyone doing this — typical account minimums are now a lower $100,000-$200,000, while Fidelity offers it for $4.99 a month and no minimums — making that chunk of the promise an assured outcome.
Meanwhile, the second part of the pledge — a boost in after-tax profits — is less guaranteed.
“You look at all of the research, you look at all of the literature where everybody talks about loss harvesting, and they say that it’s just a matter of fact you’re going to do better,” said Mayukh Mukherjee, a partner, co-founder and chartered financial analyst at AlphaWorks, a quantitative equity portfolio management and research firm in Jersey City, New Jersey. “This is completely false advertising.”
By tax-loss harvesting — intentionally selling individual stocks that decline, then using the losses to offset taxable gains on winners — investors can take home more profit. The money raised from selling can then go immediately into other securities — if they’re the same stocks, an investor has to wait 31 days to repurchase them under IRS wash-sale rules. The technique isn’t available for ready-made funds. That’s because an exchange-traded fund, for example, has to be sold in its entirety to reap any tax losses, whereas a direct index product can be sold off piecemeal.
If an investor doesn’t have enough capital gains to soak up the losses, they can deduct up to $3,000 of losses each year against ordinary income, like wages. Unused losses can be carried forward for use in future years.
‘Tax alpha’ for all
From independent advisors to Wall Street brokerages to robo-advisors, including Wealthfront and Betterment, tax-loss harvesting is now being marketed as a no-brainer move for ordinary and modestly wealthy investors. While some investment managers have backed off in recent years from making specific claims about how much extra profit, or “tax alpha,” the strategy yields, previous assertions of the concrete benefits have stuck in the minds of some advisors.
Two of the earliest proponents of the strategy crunched numbers whose ranges appear to have had staying power. Parametric Portfolio Associates, now part of Morgan Stanley Investment Management, wrote in 2020, reprising much older studies, that the boost can be as large as 2% a year on an after-tax, after-fee basis. Aperio Group, owned by Blackrock, wrote in a 2015 study that the strategy can boost after-tax returns by 0.81% to 1.93% over a 10-year period compared to a similar index fund or ETF. The two companies are the leading providers of direct indexing accounts, sometimes called personalized indexing.
Both studies assumed that an investor is in the highest federal tax bracket and has lots of short-term capital gains, or profits realized on investments held for less than one year. So did a 2006 paper, revised in 2011, by the CFA Institute, the main trade group for chartered financial analysts; it calculated a boost of more than 10% for investors who tax-loss harvested in 2010.
Morgan Stanley’s calculation of the benefits assumes a hypothetical wealthy investor who grows a $1 million investment to nearly $3.9 million over 20 years, assuming a 7% annual return. Tax-loss harvesting can potentially save that individual around $896,000.
The upshot is that affluent investors in the highest tax brackets with short-term gains taxed at ordinary rates have the biggest opportunity to reap tax savings. The problem with the mainstreaming of direct indexing is that “it’s rarely the case” that ordinary investors are in that situation, said Luke Smith, a co-founder, partner and chartered financial analyst at AlphaWorks.
Last March, Vanguard estimated the strategy can yield more than 1% a year in additional profit for investors with lots of capital gains. But the fund giant’s analysis assumed investors in two of the highest tax brackets (32% and 37%, the top) and living in California, the highest tax state with a top rate of 13.3%, along with “unlimited” capital gains. More middling investors would profit less, it cautioned, adding that for investors with a “tax alpha” of less than 1.5%, direct indexing — like Schwab, it uses the term personalized indexing — “may come at a significant cost in terms of lower expected return from the entire portfolio.”
Cerulli Associates said last August that growth in direct indexing now outpaces that of traditional products like mutual funds, exchange-traded funds and separate accounts that don’t use the strategy. The strategy had $362 billion in assets in 2020, with roughly one in five retail investor accounts in direct indexing products, Cerulli said. Morgan Stanley and Oliver Wyman see the industry, whose assets more than tripled over 2015-2020, holding $1.5 trillion in assets come 2025. For contrast, passive index ETFs held $6.3 trillion in 2021.
“For many, direct indexing will be the future of investing,” wrote Adam Grealish, the head of investments at Altruist, a custodian for registered investment advisors, in a June op-ed in Kiplinger.
But the fees paid for direct indexing products can chip away at the tax benefits. Fees for Schwab Personalized Indexing accounts start at 0.40% — the average for all U.S. mutual funds and ETFs last year, according to Morningstar — with a minimum investment of $100,000. That’s 10 times the amount of the 0.04% fee for the Vanguard 500 Index Fund. “The fees are likely to overwhelm the tax benefit,” Smith said.
The technique is an all-in bet. Mukherjee called direct indexing a “Hotel California” strategy that locks in investors, and the fees they pay for it, for life. Dumping the strategy means that “when it comes to tax time, you have all of the hundreds, if not thousands, of trades” that you have to pay an accountant to process for your federal and state returns.
In a blog titled “The Mirage of Direct Indexing” and posted on the CFA Institute’s website, Nicholas Rabener, the managing director of Factor Research, an analytics firms in London, wrote that direct indexing is just another term for higher-cost active portfolio management — only instead of a skilled investment manager picking the stocks, you, the investor, are. While fees for direct indexing portfolios tend to be lower than those for stock mutual funds, “investing based on personal choice is unlikely to outperform already poorly performing fund managers,” he wrote.
Both Aperio and Parametric note that the strategy isn’t for everyone. In a July 4 article in Tax Notes, a trade publication, a senior tax economist at Aperio said that the technique “may be inappropriate for taxpayers who don’t anticipate ever having sufficient capital gains to fully absorb a capital loss carryover.” The strategy, Lincoln Fleming added, “typically isn’t free — it may involve costs in the form of increased portfolio tracking error, management fees or trading costs.”
Parametric says that it uses tax-loss harvesting “only if the tax benefit offsets the transaction costs and if tracking error can be kept within a predetermined margin.” Tracking error is when the performance of stocks deviates from the index they are mirroring.
Andrew Hambleton, an associate financial life advisor at Telemus Capital in Chicago, said that tax-loss harvesting works best for individuals who pay top ordinary tax rates. “People in lower tax brackets, we don’t use it as much because it’s not necessary.”