How direct indexing could work for you

Take advantage of an investment strategy that only institutional or ultra-wealthy investors had access to in the past. Increase the after-tax return of your investment portfolio. Create your own index fund to invest in what matters to you. It’s tempting to dismiss these marketing claims as hyperbole, except that they come from some of the most well-known and respected names in the investment world, including Fidelity, Schwab and even Burton Malkiel, author of the classic investment. A random walk down Wall Street.

The fanfare speaks of a controversial trend: A growing number of investment firms are now offering Main Street investors a strategy called “custom” or “direct” indexing that typically requires buying and trading stocks directly, imitation of an index. Investment firms and advisors have long offered this strategy to the wealthy for an annual management fee that often amounts to more than 1% of portfolio value. But now, activated by commission-free trading, smart supercomputer programs and the ability to buy fractional shares, at least three companies – Fidelity, Schwab and Wealthfront – are repackaging the service for cost-conscious index investors. The new offerings let you get started with custom indexing with portfolios as small as $1, for fees ranging from $4.99 per month to 0.4% per year (see table below).

There are two main types of these new programs. One focuses on customizing your portfolio by allowing you to invest in thematic baskets of individual stocks—green energy companies, for example, or to fit a broader index by eliminating companies you might object to or in which you hold significant positions elsewhere. The other type, which generally allows less customization, is focused on tax efficiency, focused on reap investment losses to offset gains or income and reduce your bill on April 15.

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Why not just pick the stocks on your own? Few average investors have the time and expertise to buy and potentially manage hundreds of stocks in a way that replicates an index or to constantly trade money-losing stocks for similar issues in order to lock in stocks. tax losses.

Healthy skepticism for direct indexing

Any new offer from Wall Street must be closely scrutinized. And this one has a lot of critics: Rick Ferri, financial adviser and president of the John C. Bogle Center for Financial Literacy, questions the fees and wonders if personalized wallets could make it more difficult to transfer assets from the provider who built the custom. index.

When it comes to tax efficiency, investors will have to weigh any benefit against the increased complexity of their tax filings: Schwab (which requires potential new clients to have a free consultation with one of its advisers) warns its Custom index investors expect 1099 tax forms that may exceed 50 pages, for example. And some individual investors might consider the minimum investment at Schwab and Wealthfront – $100,000 – rather high.

Reasons to invest

Even boosters, including fund-research giant Morningstar, which plans to roll out a direct indexing program to be sold through advisors in late 2022, admit these new indexes aren’t for everyone. world. Daniel Needham, president of Morningstar’s Wealth Management Solutions, urges investors to protect their basic savings first by building an emergency fund and using tax-advantaged retirement savings accounts to invest in the proven mix of stocks. and low-cost bond index funds. Once that’s done, he says there are three main reasons why an investor might consider a custom index:

Preferences. Although there are already over 10,000 mutual funds and exchange-traded funds with almost every conceivable combination of stocks, some investors may prefer to build a portfolio of individual stocks to address ethical or other concerns. However, customization may be limited. Clients of Fidelity-managed FidFolios can drop up to five stocks or two industries from Fidelity’s predefined portfolios; Currently, Schwab clients can only ban three stocks after selecting a portfolio.

Balance. Employees of companies that offer significant equity compensation (tech companies, for example) may want to limit exposure to technology elsewhere. They could create a custom index that avoids tech stocks that make up more than a quarter of the S&P 500, a diversification that could reduce overall portfolio risk.

Taxes. Investors at high tax brackets who expect to realize large capital gains can use custom indexing to accelerate the reaping of tax losses in taxable brokerage accounts. The technique involves selling an investment that has fallen in value and using the losses to offset the capital gains taxes of other investments (or up to $3,000 of income if the losses exceed the gains). To stay fully invested, investors use the proceeds to buy something similar.

This requires expertise, because the IRS”washing saleThe rule penalizes you if you switch to investments that look “substantially identical” to anything you’ve sold in the past 30 days. You can’t sell and then redeem GM stock over the next month, for example. But you can sell GM and buy Ford

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Custom Index Comparison
Last name Costs Minimum investment Primary objective Types of accounts
Fidelity Solo FidFolios $4.99/month $1 Personalization Taxable and some IRAs
FidFolios managed by Fidelity 0.4%/year $5,000 Tax loss harvest Taxable
Schwab Custom Indexing 0.35%-0.4%/year depending on invested assets $100,000 Tax loss harvest Taxable
Wealthfront US Direct Indexing 0.25%/year $100,000 Tax loss harvest Taxable

Losses are plentiful these days in mutual funds and ETFs, of course, but proponents of direct indexing say that owning individual stocks allows you to profit from losses that might be masked by the overall return of a broad index fund. “Even in a good year, 20% to 30% of stocks will be down,” says DJ Tierney, senior portfolio strategist for Schwab Asset Management Solutions.

Boosters say tax-loss harvesting can be worth the work. Wealthfront research indicates that in the five-year period ending April 30, after-tax returns for the firm’s US Direct Indexing clients were typically 0.4 to 0.8 percentage points per year in ahead of what they would have been had they stuck with ETFs and used standard tax-loss harvesting strategies.

Malkiel, chief investment officer at Wealthfront, says tax loss harvesting is one of the only exceptions he makes to his passive index investing advice: “I absolutely believe in direct indexing. It is really very useful in times like this, when the market has fallen so strongly.

But other cost-conscious investment advisers say most investors don’t pay enough tax to make the strategy worthwhile unless they expect large capital gains. It should come as no surprise that a complicated tax strategy is more profitable for those with high tax bills. For everyone, custom indexing, it seems, is like hiring a tailor to make a bespoke shirt. Creating a personalized stock portfolio for a fee could be a luxury to invest in only after taking care of the necessities.

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