Absolutely, Positively, Yes! Direct Indexes Make Sense for Investors Worth Less Than $1MM and Over $5MM
Don Cody August 31, 2024
Absolutely, Positively, Yes! Direct Indexes Make Sense for Investors Worth Less Than $1MM and Over $5MM (Part 1)
We respond to Jerry Michael's response to Brent Sullivan's original post on LinkedIn on common objections to direct indexing.
I met Jerry Michael on a tax-aware investing panel we both participated in at an Envestnet conference over twenty years ago. At the time, Jerry had recently started Smartleaf, and I was publishing an online newsletter called The Tax-Efficient Investor. I'm in awe of Jerry's accomplishments since, with Smartleaf's exponential growth.
Brent is a new online acquaintance. His LinkedIn presence as a tax-savvy content provider and his ADVDB offering have dramatically expanded his already impressive resume.
Given the lively interchange between the two, I felt compelled to jump in. I've retained all their comments and expanded the conversation with my own. For the sake of brevity, I've decided to break it into a series to cover it all and give it the full attention it deserves. Below is Jerry's post commenting on Brent's original post. My comments as GMAM (Global Macro Asset Management) follow. I, too, am solely responsible for any errors.
Gerard Michael August 16, 2024, 26 min read
Yes, Direct Indexes Make Sense for Investors Worth Less Than $1MM and Over $5MM
We respond to a post by Brent Sullivan of The Tax Alpha Insider reporting common objections to direct indexing.
Brent Sullivan, author of the excellent The Tax Alpha Insider, recently posted a summary of what he's hearing from advisors about direct indexes. What emerges is that many advisors believe that $1MM - $5M is the "sweet spot" for direct indexing, that below $1M "the juice isn't worth the squeeze" and that above $5M "Direct indexing is a gimmick". (Brent isn't necessarily endorsing these positions – he's just reporting)
We respectfully disagree with this take, however common: our (apparently) contrarian view is that direct indexes make sense both for clients below $1mm and above $5M.
I wish to thank Brent for generously reviewing an earlier draft of this post and providing additional comments, which are included below. Any errors that remain are, of course, solely my responsibility.
Below $1m
Brent lists the top 5 reasons why advisors think direct indexing doesn't make sense for investors with less than $1mm:
Objection: Number of positions
Jerry's Response: "Number of positions" is something of a catch-all objection, a variant of "meh, too complicated". But if you find working with direct indexes to be fussy or time consuming, you're doing it wrong. The management of direct indexes can be automated, making direct indexes as simple to work with as ETFs (if that's not your experience, call us).
The number of positions is a barrier for smaller accounts if there are per-ticket commissions, but most major custodians now have $0 commissions, eliminating this concern.
Comment from Brent: "An adviser yesterday mentioned that transitioning individual stocks is a royal pain (vs. an ETF). Another adviser mentioned that "the number of line items on the performance report didn't fit into a one-pager" and simply declined to consider individual stock positions any further."
GMAM's Response
All good points, but:
- Automation vs. Complexity: Yes, automation helps, but the more positions, the greater the likelihood of human or automation error. While automation certainly reduces manual errors, the complexity introduced by managing hundreds of positions increases the potential for discrepancies. Compact DITM's approach of limiting positions to a maximum of 22 significantly mitigates these risks, ensuring that the process remains streamlined and less prone to human and system errors.
- Commissions and Trading Impact: You're right that not all custodians are commission-free. However, beyond commissions, trading impact and slippage become significant concerns, particularly when trading lower liquidity stocks, which is almost inevitable when managing 200+ positions. Compact DITM addresses this by limiting trades to 22 holdings per asset class, typically focusing on the largest cap stocks. This approach minimizes exposure to illiquid stocks, reduces potential slippage, and ensures that our client's portfolios can efficiently capture the intended market returns without the drag of unnecessary trading costs.
GMAM on Brent's Comment: Transitioning from a portfolio of individual stocks can be challenging, but it's significantly easier when dealing with 22 stocks rather than 200 plus. This simplifies the transition process and makes the ongoing management and reporting much more straightforward for both advisors and clients. Not only does this streamline the transition process, but it also makes the ongoing management and reporting much more straightforward for both advisors and clients.
The image below compares two statements from the same brokerage firm. The statement for their proprietary US Large Cap direct index product is on the left, resulting in 17 pages containing 248 securities!1 We've labeled it "Traditional DI" because it is representative of the typical industry offering where clients often face hundreds of line items that can overwhelm even the most experienced investors. GMAM's Compact DITM statement - 2 pages with 22 stocks, is on the right and custodied on the same brokerage platform. Not only is transitioning easier, but also results in reduced tax accounting and avoiding having to wrestle with hundreds of proxy statements. It also means clients won't need a magnifying glass to decipher their monthly statements, which means engagement with their investments and advisors will likely improve as a result.
This concise approach simplifies transitions, reduces tax accounting burdens, and eliminates the hassle of dealing with hundreds of proxy statements. The cleaner, more digestible statement encourages better engagement with investments and advisors, likely leading to improved client satisfaction.
1Both portfolios are real-world $25,000 portfolios. While Traditional DI portfolios often contain even more securities, Compact DI portfolios are intentionally limited to 22 stocks. An often-overlooked fact is that if a client wants to be diversified globally (which we believe they should), they could be looking at a total portfolio of 500 to 1,000 or more securities under the Traditional DI approach! In contrast, GMAM's Compact DI would consist of just 44 stocks by combining our US Large Cap and International Developed Markets strategies.