Morningstar - Q3 2023 - 10

Dispatches
Is Direct Indexing for
the Masses?
Only a small subset
of mutual fund
investors might benefit.
IVORY TOWERS
John Rekenthaler
Once marketed solely to the very wealthy, direct
indexing has gone mass market. Schwab SCHW
offers a service for a minimum investment
of $100,000, while Fidelity's entry requirement
is a mere $5,000. Vanguard offers direct indexing
only through financial advisors, but CEO Tim
Buckley says the company is " investing heavily "
in the capability.
Direct indexing consists of sampling the stocks
of an equity index directly rather than through a
fund. One reason to do this is to implement
shareholder preferences, such as environmental,
social, and governance factors. However,
because many index funds also incorporate such
preferences, and the expected payoff for
indulging one's personal inclinations is exactly
zero, this motivation is unappealing.
What interests me is a more tangible potential
benefit: tax reduction. We can determine who
might benefit courtesy of a white paper published
late last year by Morningstar1
and calculations
supplied by Aperio, a unit of BlackRock BLK. My
emphasis is not what direct indexing can do for its
traditional customer base of extremely affluent
investors, but instead for the broader marketplace
of mutual fund investors.
Eight Predictors of Success
Direct indexing can be used to generate capital
losses to offset gains in other accounts.
While the IRS permits taxpayers to deduct
$3,000 worth of capital losses against ordinary
income, direct indexing is generally worthwhile
only for those who hold significant amounts
of tax-inefficient investments in taxable accounts,
such as high-turnover stock accounts or
actively managed funds. With frequencies that
range from monthly to as often as daily, the
computer programs that oversee direct-indexing
portfolios " harvest " those stocks that sell
below their cost basis while keeping the winners.
The program reinvests the proceeds into the
stocks of companies resembling the ones that
were dropped. Rinse and repeat.
The effectiveness of direct indexing varies widely
by personal circumstance. Eight factors determine
the potency of the strategy.
1 Federal tax bracket: High
The higher the investor's federal tax bracket,
the greater the potential benefit.
2 State tax bracket: High
Direct indexing helps Californians more than
Floridians.
3 Size of direct-indexing pool: Large
The more money in the direct-indexing investment
pool, relative to the participant's tax-inefficient
investments, the more likely that pool can fully
offset capital gains.
4 Replenishment of directly indexed pool:
Ongoing
The more frequently the directly indexed
pool is replenished with new assets, the better
it can offset capital gains because (barring
a prolonged bear market) the new assets will
boast a relatively high cost basis.
5 Schedule D capital gains? Yes
Short-term capital gains from some types of
investments appear on Schedule D of the federal
tax form, while those from other investment
types do not. This distinction makes a meaningful
difference for direct indexing's tax benefits,
as I will discuss later.
1 Straehl, P. & Kunzweiler, A. 2022. " Sizing Up the Potential Tax Benefits of Direct Indexing. " Morningstar Investment Management.
10
Morningstar Q3 2023
6 Type of capital gains: Short term
Because short-term capital gains that appear
on Schedule D are taxed at a higher rate
than long-term gains, they benefit more from
direct indexing.
7 Market environment: Volatile
Choppy markets, punctuated by the occasional
crash, offer more potential capital losses than an
ongoing bull market.
8 Pre- or post-liquidation: Pre
Tax-reduction techniques are largely taxpostponement
techniques, so their effects are
strongest for portfolios that are retained rather
than liquidated. Direct indexing is thus
particularly well suited for assets that are to be
either donated or passed along to heirs.
Stock Market Effects
The first thing to note is that the amount of
tax benefit conferred by direct indexing depends
heavily on the stock market environment.
Extended downturns permit shareholders to realize
steep capital losses. Bull markets that lift all
boats provide substantially fewer opportunities.
Morningstar's paper illustrates the power of
the stock market effect. The authors compute the
annualized tax benefit from direct indexing
for a hypothetical investor over a 23-year stretch,
then demonstrate how that outcome varies,
depending on the period selected. I show their
findings in EXHIBIT 1 , rescaling their results
so that the average annualized tax benefit and
the average annualized equity return over
the whole period equal 100. Direct indexing's tax
benefits have been inversely related to equities'
gains. When stocks have struggled, as they
did around the dot-com crash, the tax benefit from
direct indexing has been relatively high. In
contrast, when they have shone, it has dwindled.
Expect that pattern to persist.
Underlying Assumptions
Direct indexing does not confer meaningful
tax benefits unless the investor realizes a
significant amount of capital gains in taxable

https://www.morningstar.com/stocks/xnys/schw/quote https://www.morningstar.com/stocks/xnys/blk/quote https://mp.morningstar.com/en-us/lp/sizing-up-the-tax-benefits-of-direct-indexing

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