Take advantage of an investment strategy only very high net worth or institutional investors had access to in the past. Increase the after-tax return of your investment portfolio. Create your own index fund to invest in what matters to you. It’s tempting to dismiss these marketing claims as hyperbole, except they come from some of the best-known and most respected names in the investing world, including Fidelity, Schwab, and even Burton Malkiel, author of the investment classic. A random walk down Wall Street.
The fanfare is about a controversial trend: A growing number of investment firms now offer Main Street investors a strategy called “custom” or “direct” indexing that typically requires buying and trading stocks directly, imitating an index. Investment firms and advisers have long offered this strategy to the wealthy for an annual management fee that is often more than 1% of the portfolio’s value. But now, enabled by trading without commission, smart supercomputer programs and the ability to buy fractions of shares, at least three companies (Fidelity, Schwab and Wealthfront) are retooling the service for cost-conscious index investors. The new offers let you dabble in custom indexing with portfolios as small as $1, for rates ranging from $4.99 a month to 0.4% a year (see table below).
There are two main types of these new programs. One focuses on customizing your portfolio by allowing you to invest in thematic baskets of individual stocks:green energy companies, for example, or to tailor a broader index by removing companies that you may oppose or have large positions in elsewhere. The other type, which typically allows for less customization, has to do with tax efficiency, focused on reaping investment losses to offset gains or income and reduce your bill on April 15.
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Why not pick the stocks on your own? Few average investors have the time and experience to buy and manage potentially hundreds of stocks in a way that replicates an index or to constantly trade stocks that lose money for similar problems to lock in tax losses.
Healthy skepticism for direct indexing
Any new Wall Street offer should be scrutinized. And this one has plenty of critics: Rick Ferri, financial adviser and president of the John C. Bogle Center for Financial Literacy, questions the fees, wondering if custom wallets could make it harder to move assets from the provider that created the custom one. index.
When it comes to tax efficiency, investors will have to weigh any advantages against the increased complexity of their tax returns: Schwab (which requires potential new clients to have a free consultation with one of its advisers) warns its investors against indexing Custom expecting tax 1099 forms that can exceed 50 pages, for example. And some individual investors might consider the minimum investment in Schwab and Wealthfront ($100,000) on the high side.
Reasons to invest
Even pushers, including fund research giant Morningstar, which plans to roll out a direct indexing program to be sold through advisors by the end of 2022, admit these new indices aren’t for everyone. Daniel Needham, president of Morningstar Wealth Management Solutions, urges investors to first protect their critical savings by creating an emergency fund and using tax-advantaged retirement savings accounts to invest in the proven mix of low-cost stocks and bonds. cost. index funds. Having done that, he says there are three main reasons why an investor might consider a custom index:
Preferences. Although there are already more than 10,000 mutual and exchange traded funds with almost every conceivable combination of stocks, some investors may prefer to create a portfolio of individual stocks to address ethical or other concerns. However, customization may be limited. Fidelity-managed FidFolios clients can scrap up to five stocks or two industries from Fidelity’s preset portfolios; for now, Schwab clients can ban just three stocks after selecting a portfolio.
Balance. Employees of companies that offer significant compensation in stocks (tech companies, for example) may want to limit technology exposure elsewhere. They could create a custom index that avoids technology stocks that make up more than a quarter of the S&P 500, diversification that could reduce overall portfolio risk.
Taxes. investors in high tax brackets Those expecting significant capital gains can use custom indexing to boost tax loss collection on taxable brokerage accounts. The technique is to sell an investment that has declined in value and use the loss to offset capital gains taxes on other investments (or up to $3,000 in income if losses exceed gains). In order to remain fully invested, investors use the proceeds to buy something similar.
This requires experience, because the IRS “wash sale” penalizes you for switching to investments that appear “substantially identical” to what you sold in the last 30 days. You can’t sell and then buy back GM stock within the next month, for example. But you can sell GM and buy Ford
|Name||Rate||minimum investment||Main goal||account types|
|Fidelity Solo FidFolios||$4.99/month||$1||Personalization||Taxable and some IRA accounts|
|FidFolios managed by Fidelity||0.4%/year||$5,000||Tax Loss Harvest||Taxable|
|Schwab Custom Indexing||0.35%-0.4%/year depending on the assets invested||$100,000||Tax Loss Harvest||Taxable|
|Wealthfront US Direct Indexing||0.25%/year||$100,000||Tax Loss Harvest||Taxable|
Losses are plentiful these days in mutual funds and ETFs, of course, but promoters of direct indexing claim that owning individual stocks allows you to take advantage of losses that might be hidden by the overall performance of a broad index fund. “Even in a good year, 20-30% of the stock will fall,” explains DJ Tierney, senior portfolio strategist at Schwab Asset Management Solutions.
Boosters say collecting tax losses may pay off. A Wealthfront study says that for the five-year period ending April 30, the after-tax returns of US direct indexing clients used standard tax loss collection strategies.
Malkiel, Wealthfront’s chief investment officer, says tax loss collection is one of the only exceptions he makes to his passive index investment advice: “I absolutely believe in direct indexing. It’s really very useful at times like this, when the market has fallen so sharply.”
But other cost-conscious investment advisers say most investors don’t pay enough in taxes to make the strategy worthwhile, unless they expect big capital gains. It should come as no surprise that a complicated tax strategy is more profitable for those with high tax bills. To everyone else, custom indexing seems like hiring a tailor to make a custom shirt. Creating a custom stock portfolio for a fee can be a luxury to invest in only after the needs are taken care of.
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