At what point is it smart to use direct indexing for a client’s portfolio versus holding ETFs? According to new analysis from Dr. Stephanie Lo, chief research officer at fintech startup NDVR, there are only a few scenarios where direct indexing provides better after-tax returns for long-term portfolios.
Lo spoke with VettaFi contributor Dan Mika about her research. Additionally, Lo discussed how advisors can apply it in their practices with direct indexing-curious clients.
VettaFi: Direct investing has been a point of interest for the investing industry for a few years. What inspired you to do this specific research now?
Lo: As direct indexing has gained popularity, several companies have introduced new solutions at lower fees and with lower investment minimums. This has caused more investors to contemplate using direct indexing. However, even with lower fees, investors should be cautious.
Equities have performed well over the past several years. And investors who are holding diversified ETFs might end up worse off if they incur transition costs to enter direct indexing. My research provides a framework to help these investors decide whether to stay in an ETF or transition to a direct indexing offering.
VettaFi: Walk me through why the supposed value of tax alpha harvesting declines the longer a client’s portfolio is wrapped up in an ETF before it’s transferred to a direct index account. How much does the thinking around choosing direct indexing versus an ETF change if someone is investing for the first time and has no embedded capital gains?
Lo: The main factor influencing the transition costs to direct indexing is the level of embedded capital gains within the ETF. If these gains are realized during the transition, the investor will face immediate capital gains taxes. That is reflected in the cost of switching to direct indexing. Alternatively, the investor could remain in the ETF. That allows for tax deferral and further compounding of returns.
Due to price movements over the past decade, the level of embedded capital gains generally correlates with how long the client’s portfolio has been held in an ETF. Although that isn’t always the case. Clients should review their percentage of embedded capital gains directly. That can typically be found in their portfolio performance reports.
The case where an investor starts from cash is embedded in my analysis as the 0% embedded capital gains case. I also wrote a follow-up LinkedIn post that investigates the “start from cash” case in more detail. Under many reasonable assumptions, direct indexing can be beneficial. But this depends on the direct indexing program’s fees and the investment horizon.
Higher fees and a longer horizon may favor choosing an ETF instead. For instance, the direct indexing solution might be 35 basis points more expensive than the ETF. Then, it may make sense for a cash investor to choose the ETF, regardless of the investment horizon. The investor’s individual tax situation and inheritance goals are also important factors. So each case should be evaluated separately.
VettaFi: What general guidelines would you give to financial advisors who are fielding questions or trying to gauge how appropriate direct indexing would be compared to holding an ETF? Your work shows that direct indexing would carry some advantages for inheritance-focused investors who will have a step-up basis. Are there other factors in a client’s profile that would make direct indexing a better value proposition?
Lo: My analysis indicates an investor’s tax situation, investment horizon, relative costs, and inheritance motives are all important factors. Tax situations can be particularly complex, and an advisor should understand potential changes in an investor’s tax situation over time when assessing the cost-benefit of direct indexing.
I would also emphasize the importance of understanding the motives behind choosing direct indexing. Are nonpecuniary factors at play. For example, such factors as the desire for increased customization or the need to build a completion portfolio around an existing concentrated position? Is the investor concerned about tracking error relative to the benchmark? These questions go beyond the scope of my analysis.
Finally, I would encourage advisors to help their clients think outside the box. For certain clients, a long/short direct indexing strategy might be appealing. Although I didn’t include this in my analysis — since long/short strategies have yet to gain traction among the mass affluent — it could be worth further exploration.
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