All the way back in 2020 I offered some speculative predictions about the future of so-called “direct indexing.” This is the logical end point of the proposition, promoted by the tax-evasion industry, that by swapping between closely-correlated-but-not-identical securities, those with taxable investments can generate capital losses that can be used to offset capital gains or deducted over time against ordinary income without losing their overall exposure to stock market returns.
Of course, the wealthiest investors and institutions already have access to direct indexing: if you have a billion dollars invested you don’t own a total stock market index, for the simple reason that even a 0.04% management fee translates to hundreds of thousands of dollars a year.
The biggest obstacle to direct indexing is just what you’d think: to reflect the performance of an entire passive index, you’d need to buy every stock in the index. To capture capital losses without losing fidelity to the performance of the index, you’d also need to know the correlation between the prices of every stock in the index. That’s of course technologically possible, but it’s not practical for most people to do on their own at home.
Instead of owning every stock in the index, a retail investor might own just a subset of “representative” stocks. For example, glancing at the holdings of Vanguard’s Communication Services ETF VOX, I see the 1st and 10th largest holdings are Alphabet and Activision Blizzard. Using those two stocks, and two stocks in every S&P sector, to “weight” your holdings according to their share of the S&P 500 reduces your total US holdings down to just 22. If the largest holding in a sector drops and generates a capital loss, sell it and replace it with the second largest. If the 10th-largest holding generate a capital loss, sell it and replace it with the 9th-largest. Still onerous, but manageable at least.
Unfortunately, this would greatly reduce the accuracy with which your homemade direct indexing tracks the index whose performance you’re trying to replicate! After all, after replacing Alphabet with Meta, what reason do you have to believe Meta will replicate Alphabet’s returns going forward? Why would T-Mobile US replicate Activision Blizzard’s returns?
Alternately, you can simplify things even further and hold sectoral index funds directly. Instead of buying the holdings of VOX directly, you can buy VOX, and if you have the opportunity to harvest capital losses, swap it out with a similar-but-not-identical sectoral ETF, like the iShares S&P Communication Services Select Sector Index XLC. Now instead of owning 22 stocks, you own just 11 ETF’s, simplifying your life and maintaining much closer fidelity to the underlying index you’re trying to track!
Schwab Personalized Indexing claims it will solve the technological hurdles
Late last month Schwab announced it was launching a direct indexing product aimed at the merely affluent: those with $100,000 or more in taxable assets, at a fee of 0.4% per year. As I mentioned above, the hurdles are primarily technological, so spreading the cost of tracking thousands of prices in thousands of separately managed accounts across as many people as possible minimizes the cost to each participant: $400 per year at the entry $100,000 account size. If Schwab is able to generate an average of $3,000 in capital losses per year without sacrificing performance, then investors’ marginal income tax rate needs to be just 13.3% to break even.
There, of course, is the rub: Schwab certainly has the money, customer base, and talent to solve the technological hurdles to direct indexing. But investing is never entirely mechanical. The inclusion of companies in Standard and Poor’s indices is famously political, with the inclusion of Google in 2006 and Tesla in 2020 being especially contentious.
Direct indexing offers the promise of replicating the performance of an index by swapping closely-correlated shares. But over what timeframe should they be correlated? Over some fixed period, whether 1, 5, or 10 years? Over the entire history of the companies? Making these judgment calls is necessary, but the more judgment calls you have to make, the more this strategy of “indexing” begins to look like active management.
Direct indexing, like all investing, works better with the regular application of new funds
None of the above should be read as a criticism. On the contrary, I’m cautiously optimistic about Schwab Personalized Indexing bringing tax-loss harvesting to a larger share of retail investors. There are three things to keep in mind about direct indexing, however. First, whenever you swap out of a stock that has undergone losses, and then back into it later at a lower price, you realize an upfront, deductible loss today, but lock in a lower cost basis when you eventually sell. Given the tendency of share prices to rise over time (due to inflation if nothing else), this is very likely over time to increase your total quantity of capital gains later on in life. Of course, capital gains are taxed extremely favorably, and many people have a lower marginal income tax rate in retirement than during their working years, so this may be a reasonable tradeoff — it’s just one you need to be aware of.
One corollary of this is that tax loss harvesting works best when new funds are added regularly, locking in an increasing cost basis for your newly acquired shares and increasingly the likelihood of realizing additional capital losses in the future.
The final corollary is that tax-loss harvesting (and indeed, direct indexing) are another scam lodged our tax code to facilitate the intergenerational transfer of wealth between the wealthiest people human history. If you’re rich enough to have hundreds of thousands of dollars in taxable investments, then you’re rich enough that you’ll never have to spend a penny of it yourself. But due to the stepped-up basis scam and ridiculous gift and estate tax exemptions, driving down the cost basis of your taxable investments is a way of ensuring not only do you pay as little tax as possible in life, but that your heirs will never pay a penny in tax on your capital gains, either.