Morningstar - Q3 2022 - 15

leverage proprietary technology to optimize your
portfolio and monitor it on a daily basis.
An unconvincing list. Because they are available
in hundreds of flavors, standard index
funds can better reflect an investor's personal
tastes than can the three indexes used by
Schwab's direct-indexing service, even if those
benchmarks are supplemented by the
ability " to exclude a limited number of stocks. "
And standard index funds, of course, are also
" professionally managed. "
For example, as of April, there are 124 exchangetraded
and mutual funds that index while
using ESG criteria, 71 of which cost less than
Fidelity's and Schwab's direct-indexing
services. As most investors will accept the ESG
selections made by investment professionals
rather than conduct their own research,
it's not clear that direct indexing will capture much
of the ESG marketplace. Nor will direct indexing
necessarily attract those who possess other
investment preferences.
While it is true that there is limited reason to
adjust a benchmark's holdings, and that the
boast of professional management is immaterial,
since the same attribute applies to index
funds, the strategy's tax benefit cannot be so
readily dismissed. Unlike index funds,
directly indexed portfolios can deviate from their
benchmarks by selling their losers. Thirty-one
days later, by the terms of the wash-sale
rule, investors may repurchase those same shares.
The index position is restored, with a capital
loss booked.
Tax Advantage?
To start at the beginning: All investments
contained within taxable accounts (forget about
direct indexing in tax-sheltered locations,
such as 401(k) plans or IRAs) must distribute their
aftercost income, that being interest receipts
or dividends. With investment income, there can
be no escape from the taxman.
Although the same rule applies to capital
gains from the sale of securities, this liability,
unlike income, can often be controlled.
Stock shareholders can avoid taxes merely by
refraining from transactions, or they can
use the more complex method of offsetting their
profitable trades with realized losses.
The latter is achieved by both ETFs and direct
indexing, albeit in different fashion. ETFs
can manage their capital gains through their
" creation-and-redemption mechanisms. " The
process for neutralizing capital gains when direct
indexing is more straightforward. When
one stock is sold for a profit-which does not
often occur with indexing strategies-a
direct-indexing service can offset that gain by
selling a corresponding loser.
In short, an ETF that invests in a conventional
index and a direct-indexing program arrive
at the same tax destination. In each case,
the portfolio receives taxable income, but it will
not generate a capital gains liability until the
shareholder exits the investment. (To be sure,
more exotic ETFs sometimes do make capital gains
distributions, but as no unadorned S&P 500
ETF has made such payouts during any of the past
10 years, I stand by the generalization.)
So far, so meh. Retail investors can pay 5 basis
points each year for a broad-market ETF
that distributes no capital gains, or they can pay
25 to 40 basis points for a direct-indexing
program that accomplishes the same task. That
is an easy call for a stand-alone portfolio,
or for the sole taxable account of those who
possess various tax-sheltered investments. Save
money by joining the masses.
The Game Changer
There is, however, an exception. If the directindexing
assets are but one segment of a
taxable account, with the other segment often
producing high capital gains, then direct
indexing can be a godsend. There is no way during
a bull market, or even in a bear market for
investments that have been held for a long time,
to realize capital losses with an ETF. If the
fund is sold, it will realize a profit. But within a
direct-indexing portfolio, there will surely
be losers to harvest.
The tax benefit is highest when direct indexing is
used to offset holdings that distribute hefty
morningstar.com/products/magazine
15
short-term gains, as with hedge funds. Because
such gains are treated as ordinary income,
their effective tax rate can reach 50% in high-tax
states. Consider a hedge fund that pays 5% of its
assets in short-term gains, thereby creating
a 2.5% IRS bill. Owning a direct-indexing portfolio
that can erase that liability, rather than an
ETF that cannot, is clearly the superior choice.
(Another situation that shows direct indexing
to best advantage is when an investor diversifies
from a profitable position in company stock.)
It may be protested that postponing taxes is not
the same as eliminating them. Eventually,
those securities must be sold. But that objection is
not strictly correct, because those investments
may be passed as a bequest or given to charity,
in which case their tax benefits are preserved.
Also, money possesses time value. Paying
obligations later rather than sooner is a generally
sound strategy.
In summary, the primary appeal of direct indexing
is its relief for taxable accounts, the amount
of which will vary according to the investor's
wealth and capital gains status. Under the
right circumstances, investors certainly should
be direct indexing.
But although direct indexing has merit, it is
not for most. Never mind Fidelity's $5,000
minimum, which is nobly democratic but beside
the point. Even the steeper hurdles erected by
Schwab and others are largely unrealistic.
Direct indexing helps those who have substantial
taxable assets, some of which generate
ongoing capital gains. Relatively few investors
meet that description. K
John Rekenthaler is a vice president at Morningstar
Research Services LLC. He is quick to point out that the
views expressed in Ivory Towers are his own.
https://www.morningstar.com/authors/208/john-rekenthaler http://www.morningstar.com/products/magazine
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