Investors are susceptible to “shiny object syndrome.” They have been for years, from the 1980s, when various mutual funds and tax shelters took turns disappointing investors through the tech bubble and on to crypto.
Today, direct indexing will save money on taxes and let you invest like a titan. Or so investors think.
Direct indexing is a good and useful product when properly applied. It promises more customization and tax benefits for investors who want to put their stamp on their equity portfolio. But it’s a product, not a panacea.
Enthusiasm for direct indexing masks this fundamental issue: Investors want and need their advisors to focus on managing an entire portfolio to deliver “tax alpha” and maximize retirement income.
What Direct Indexing Won’t Do
Direct indexing is an approach that allows an individual to buy all the stocks in an index in the same weights as they appear in the index. It works better for some indexes than others.
It has some downsides. Its orientation to a limited number of stocks can mean investors miss out on the growth potential with investments in smaller, less well-known companies.
And paperwork? Clients and their accountants had better brace themselves for the reams of paperwork they’ll have to deal with on their tax returns.
Even its touted benefit—tax harvesting—has limits and can, over time, yield diminishing returns. Once an investor has sold the losing stocks in a portfolio, what remains will be replacements that will each tend to have a much lower cost basis. When the time comes, selling those will realize greater capital gains and more taxes.
In other words: Problem deferred, not solved. Which explains why, historically, the wealthy have applied direct indexing to portions of their portfolios destined for legacies to charities or heirs.
Chip Roame, founder and managing partner of Tiburon Strategic Advisors, reflected in a conversation with Jack Sharry on his WealthTech on Deck podcast that industry movers and shakers have long wrestled with questions such as:
• What matters most: investment management or financial planning?
• What is the “value” an advisor provides toward an investor’s outcomes?
“When you dig in, half of it is always taxes, “Roame said on the podcast, adding, “Tax planning is the new alpha” in financial services.