Direct Indexing in Luther Wealth’s Future

In the great divide between active and passive investing strategies, Luther Wealth is definitely in the passive camp. All of my clients are fully invested in low cost mutual funds and ETFs. I use a proprietary asset allocation algorithm, but the securities themselves are just vanilla index funds. But lately I have been considering altering this ETF strategy for certain clients. Not in favor of an active strategy, but rather in favor of a different passive style known as direct indexing.

What is direct indexing?

Traditional indexing is where the investor owns a share in an investment fund. This pooled fund then buys all of the securities in an index, such as the S&P 500 equity index. Each investor then earns a return equal to the total return on all of the individual securities in the index, minus a fee. The fee is how the fund pays for fund managers and infrastructure.

In contrast, direct indexing skips the fund layer. Instead, the investor directly invests in each security in the index in proportions based on the index’s weighting rules. For example, the S&P 500 index is a market value-weighted index.

Advantages of direct indexing

This style of investing has several advantages over traditional indexing. First, the investor can save the fund management fee. This is a small benefit for the most popular indices, because competition has driven these fees down to 0.04% to 0.07%. But for less popular indices, the savings may be significant.

Second, direct indexing vastly improves the investor’s ability to take advantage of a strategy called tax loss harvesting. Tax loss harvesting is where an investor sells securities that have decreased in value in order to realize taxable losses. Tax loss harvesting is nearly impossible under a traditional passive strategy because usually there are only a few securities in the portfolio. In a direct index strategy, there might be hundreds of securities that lose value in a tax year. This can be true even in a rising market. This dramatically increases the chance for loss harvesting to work.

Finally, direct indexing gives investors more control over individual security selection. This can allow more targeted investment strategies, such as ethically conscious investing. For example, an investor could choose to invest in the S&P 500 index, less companies in the carbon based fuel industry. However, these strategies can tend to push direct indexing into more of an active strategy.

Drawbacks of direct indexing

Direct investing does have drawbacks though. First, direct indexing can result in higher trading costs. You actually have to buy each of the 500 securities in the S&P 500 index. Trading costs for a share in SPY, one of the major S&P 500 index ETFs, are very low because the ETF is extremely liquid. However, the 500th security in the index is significantly less liquid. Buying and selling that security might involve heavy commissions or spreads.

Second, tax loss harvesting can result in a portfolio drifting away from the index over time. As soon as you harvest tax losses, your portfolio becomes a bit different from the index. And the more losses you can harvest, the more diverged your portfolio will become.

Finally, tax loss harvesting can create tax hassles. Like any other tax strategy, you have to be careful to not accidentally break any rules. For example, if you harvest losses, but also participate in a dividend reinvestment program, you could accidentally trigger a wash sale.

Implementing direct indexing at LWM in the future

I would like to eventually start implementing direct indexing for certain clients at Luther Wealth. The brokerage platform I use for client funds, Interactive Brokers, has several tools to assist in direct indexing strategies. In particular, I can invest funds in various securities basket trades, and buy/sell stocks in specific tax lots.

But, it’s not a strategy for every client. At first, I would only offer this strategy to high net worth clients with available tax counsel. The benefits of this strategy would be outweighed by the higher trading commissions for lower net worth clients. And tax counsel is necessary to properly take advantage of the capital losses.

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