This portfolio will likely be a bit different than IWM. Perhaps you’re an executive at Apple with a large incentive stock option plan and a slug of company stock. Well, you might end up with a “Russell 3000 minus AAPL” portfolio that’s actually much better for you.
And perhaps you really want to minimize your exposure to tobacco companies. Well, now you have a portfolio that is essentially the Russell 3000 minus AAPL and tobacco companies. And that portfolio can be further tweaked to minimize tracking error to the Russell 3000—perhaps increasing the weights of some other consumer stocks to make up for the missing tobacco companies.
Boring Part That’s Magic
The second half of a direct indexing relationship goes beyond just excluding and tweaking—it’s how you manage it over time.
In a normal ETF portfolio, the fund manager focuses extremely closely on managing to their index, especially around rebalances, index changes or corporate actions. Each one of those small changes can create a taxable gain, and so ETFs also rely on creation/redemption to “push out” low-basis shares as often as they can. For this reason, most ETFs have never paid a capital gains distribution.
But just because they’re distributing zero doesn’t mean they couldn’t do better.
No Tax-Aware Decision Timetable
In a direct indexing scenario, the portfolio manager can make tax-aware decisions throughout the year. If Wells Fargo has a terrible quarter and trades to a loss in the portfolio, it can sell that position and book that loss, replacing the exposure with other banks.
That tax loss can be used to offset taxable gains from other positions, or it can be used to offset $3,000 in ordinary income, or it can be used to offset gains from other unrelated transactions—the sale of company stock, for instance.
For many high net worth investors, that single-stock tax loss harvesting is a kind of magic that “cracks open” their portfolio, spreading across the entirety of their annual IRS filings.
Many early leaders in this space have account minimums as high as $10 million. There’s some logic to those minimums, because with too small an account—say, $1 million or less—you can’t effectively manage the individual lots of securities. If the average stock price is around $60, then just owning one share of each stock in the Russell 3000 would be a $200,000 investment. And of course, trading single shares is rarely efficient.
Thankfully, there are ways around this. Many direct indexing firms now offer fractional shares. They do this by bundling all their trades across thousands of accounts together, and assuming some small level of risk in owning the “leftover” fractions of securities. That means you can, in fact, own exactly $124 worth of Berkshire Hathaway if that’s what the strategy requires.
What This Means For Advisors
Honestly, I think it’s the best development for the advisory market since the invention of the ETF. Dozens of direct indexing companies have platforms tailored to bring advisors along into this brave new world. This fundamentally enhances the client conversation through customization.
This isn’t a death knell for ETFs; far from it: It’s an evolution. ETFs will remain the vehicle of choice for millions of investors for decades to come. You’ll even see them as part of the allocations inside direct indexing accounts where they make sense (illiquid markets, alternative asset classes). But for your largest advisory clients? Now’s the time to be looking at the next big thing.