Technology has improved almost every area of our lives – why can’t it improve our investing? For those of us, that subscribe to the Dave Ramsey and Ramsey Solutions mentality of investing – which means we like the diversification benefits that mutual funds and exchange-traded funds provide us, we have always had to invest in exactly that – mutual funds or exchange-traded funds. And for many account types, that makes sense – it’s easy, and there is no reason to do anything different. However, for investors with large amounts of non-retirement money, such as brokerage accounts or Bridge Accounts, as Dave Ramsey refers to them, you’ll want to pay attention to this article. Additionally, for those clients getting ready to complete Baby Step 6 and thus will soon be building your bridge account, this article brings you good news about technology enhancements that will help you save that mortgage payment each month and create tax benefits while doing so.

The concept we’ll dive into today is called Direct Indexing. Direct Indexing is not new, but it’s growing fast! According to the 2021 edition of Competing for Growth Oliver Wyman, Inc reported that Direct Indexing has grown from $100 billion of assets in 2015 to roughly $350 billion by the year 2021, which is more than threefold growth! Talk about gaining momentum! Let’s dive into what it is, how it works, and why it could benefit you.

Understanding Direct Indexing:

We all should know what a mutual fund is, right? Hopefully, your Financial Advisor taught you about the ins and outs of mutual funds when you first met them. Essentially, your fund manager aims to diversify your risk away by purchasing a large basket of stocks that you, along with many other investors, collectively own. If you don’t like my definition, you can read Investopedia’s definition right here.

The reason, over the years, this was the only logical option for the investor that needed or wanted to spread their money out amongst many companies was cost and technology. For example, just ten short years ago, it would have cost nearly $10 / trade, at even the discount brokers, to place a trade; therefore, buying the 500 individual components of the S&P 500, for example, would have cost $5,000 in commissions and fees. No thanks – I’ll buy the Schwab S&P 500 Index Fund with its 0.02% expense ratio and hold the companies through the fund. In addition, the technology was such that buying those stocks would have taken forever, and then monitoring all those holdings would have been a task most individual investors and Financial Advisors were unwilling to commit to.

However, that has all changed. Schwab and many of the other larger brokerage firms like Fidelity, Vanguard & TD Ameritrade have lowered their trading fees to zero. Technology is moving faster than we can blink our eyes, so making those 500 stock purchases can be done in seconds, and monitoring it can be accomplished by high-speed algorithms. So holding all 500 companies in the S&P 500 (if that is the index I’m trying to replicate) is no longer impossible or cost-prohibitive. So now the only question remains – why would I want to do such a thing?

Benefits of Direct Indexing:

Tax Efficiency: One of the key advantages of direct indexing is the potential for increased tax efficiency. Since investors directly own individual securities, as opposed to a fund that owns all those securities, they can selectively harvest tax losses by selling specific underperforming stocks. These realized losses can be used to offset capital gains and potentially reduce tax liabilities. This ability to manage tax consequences more granularly can be particularly valuable for high-net-worth individuals seeking to optimize their tax efficiency.

Let’s look at how this works: Stock A drops below the initial cost that it was purchased at. It is then sold by the technology watching your direct indexed account, and a correlated (but not substantially identical, thus not to trigger the wash-sale rule) replacement stock is repurchased in its place. This loss that is created can then be used to offset other gains in your portfolio, or an investor can take up to $3,000 each year in capital losses to offset ordinary income. Those of you that remember our discussion using the Prudential Asset Allocation Chart, will remember that the stock market has historically been positive 80% of the years, over the last thirty – so is this strategy only beneficial in the 20% of years that the stock market has been negative?

Absolutely not! It should be beneficial to your tax situation every year! Take a look at this Vanguard Report that did a study to help teach the benefits of direct indexing using market returns in 2021. If you remember, 2021 was one of the best years for the market in my career. Not because of the rate of return, although the S&P 500 returned 28.66% that year, but more so because of the lack of volatility. We barely had a 5% dip that year, yet according to Vanguard, there were still 133 individual companies that lost value in the fourth quarter of 2021 alone. That was 133 opportunities if you held the individual securities, instead of the S&P 500 fund, to create tax benefits for yourself. Vanguard quantified the value created by these tax loss harvest opportunities for a high-net-worth investor to be as much as 1.32% added to your performance and 2.26% for an ultra-high-net-worth investor. Essentially the higher the tax bracket and the more potential capital gains you have, the greater the benefit of Direct Indexing.

How is this accomplished? Let’s assume you’re in the 24% Federal Tax Bracket. Taking the $3,000 in losses that could have been realized (as described above, even in a year the market had a positive return) would have tax savings of $720 in federal income taxes. Not let’s also assume that there were capital gains that were able to be avoided in that year, because of the fact that the Direct Indexing Software was able to generate a total of $5,000 in losses. $3,000 against ordinary income, and another $2,000 was used to offset other gains, now saving this person a total of $1,200 in federal income and capital gain taxes. When you start compounding that over many years, these savings really start to add up.

Customization and Personalization: Direct indexing allows investors to tailor their portfolios according to their individual preferences and investment goals. Investors can exclude specific companies or sectors that do not align with their values or include securities that are aligned with their Christian values. This level of customization allows for more personalized investing and enables investors to align their portfolios with their unique beliefs and objectives.

If you work for a publicly traded company and have the ability to purchase shares from the company at a discounted price, that can be a valuable tool; however, we may not want to continue buying that stock in your mutual funds as well; otherwise, you’ll break the cardinal rule of having more than 10% of your net worth invested in one company, specifically the company that also provides the income to your household. Therefore, with direct indexing, we can exclude your company's stock and even their entire sector from the portfolio to ensure portfolio efforts are not duplicated with your company’s stock option or purchase plan benefits and your investment advisor’s portfolio.

Cost Savings: Direct indexing can potentially result in cost savings compared to investing in mutual funds or ETFs. While traditional funds charge management fees, direct indexing often incurs lower expenses since investors can bypass the expense ratios associated with fund investments. Additionally, by owning individual securities, investors can potentially save on transaction costs, as the fees associated with trading stocks are often lower than those associated with buying and selling fund shares.

Conclusion:

Direct indexing represents a powerful tool for investors seeking greater control, customization, and potential advantages in their portfolios. By directly owning individual securities that replicate an index, investors can enjoy tax efficiencies, customize their holdings and potentially reduce costs. With its ability to align investments with personal values and objectives, direct indexing provides investors with a unique opportunity to create portfolios that truly reflect their individual aspirations. According to a recent Bloomberg article written in December 2022, the $350 billion in Direct Indexing could hit $825 billion in the next four years. With the benefits described above, talk to your Financial Advisor to see if this may be the right approach for your brokerage or bridge account.