Episode Transcript
Brenton: [00:00:00] there are people out there who see index funds and ETFs as the gold standard of investing, and there are others who prefer to pay an advisor or an investment manager to help them assemble a portfolio that fits their needs.
In this episode, we cover a new type of investing called Direct indexing and show you how it blends some of the features that you find in the index world with that of what you find with an investment manager.
Let's get started.
[00:01:00]
Brenton: Hello, my name is Brenton Harrison of New Money, New Problems, and your host for the New Money, New Problems podcast. Over the last several episodes, we've been talking about some of the ins and outs of investments. Today's episode is in furtherance of that objective because I want to talk to you about a blend of two different investment styles, those styles being index/ etf, investing with that of an investment manager by talking about a new style of investment called direct indexing.
Now, in our previous episodes, we've talked about index funds and ETFs, and one of the things that I've shared with you in terms of the things that attract investors to these styles is their low cost. If you're comparing an ETF or an index fund to a fee that you would pay with an advisor, with an index fund, you might be paying a 10th of a percent or less.
Whereas with an investment advisor or an investment manager, you might be paying a percent to the investment advisor and you might be paying an additional amount called a program fee or an account fee to utilize a third party manager. And in some scenarios, in [00:02:00] my opinion, it's worth that fee.
But for those who are index fund enthusiasts, they say it is always better to let the market do what it does because market will always beat man.
If you're following on screen, there's an article from CNBC entitled 'Billionaire Warren Buffet, swears by this inexpensive investing strategy that anyone can try'. and in this article, they talk about a bet that he made that started on January 1st, 2008 and ended on December 31st, 2017. And in this bet, Warren Buffet would put money into a Vanguard s and p 500 index fund and compare its performance cumulatively over that decade to that of five hedge fund of fund strategies. And as a recap, a fund to fund is an overarching manager or fund that inside of that portfolio invests in other mutual funds. And what they found is that after a decade, the s and p 500 won by a landslide. As a matter of fact, the fund of funds had a cumulative return [00:03:00] of 36.3% net of fees over that 10 year period, while the s and p 500 had a net return of 125%. So you're talking about a return that is almost 400% higher than what you utilize when you found an active manager who was using a hedge fund to fund strategy,
And I would say in the long run, I am a believer that market will always beat, man. That's a big reason why when I have investors who are in their thirties Who have a retirement account that they don't plan to access for three decades. I don't charge them a fee to manage it.
I say keep it where it is, diversify it, because over the course of 30 years you have so much time to let the market do what it does. And at the end you will likely have more than what you would if I were to charge you a fee to manage that account on your behalf. But it's a three quarters truth, if you recall me coining that term where it's a truth that is technically accurate, but does not tell the full story, but there's no ill intent in [00:04:00] leaving out some of the context. Because returns as odd as it sounds, is not the only thing that matters when it comes to how you choose a portfolio. And even when you compare returns, it's very crucial that you have an understanding of what you're comparing it to in terms of the time period that you're assessing.
As a matter of fact, It just so happens that in terms of the decade that Warren Buffett made his bet, it was one of the best 10 year periods of the s and p 500 in its history. While 2008 was the start of the financial crisis, it went down negative 36%, for the next nine years there was not one other year in that decade where it had a loss. Now, if you went back to the year 2000 and they had made that bet, it would be a different story Because in the year 2000, 2001 and 2002, there were negative returns in each of those first three years to start off that decade, and that brings to mind elements of picking investment that you have to consider when choosing what's right for your portfolio.
One of them is [00:05:00] time horizon, the next is risk tolerance, and the final is sequence of return risk. The time horizon is really important because while you might have an investor who thinks the best thing they can do is chase the highest return possible, if they have a time horizon of 10 years or less, five years or less, and in that period of time, they might need those funds to start a business. Or put a down payment on a home. It might not be the best strategy to seek the highest return possible because even in an index like the s and p 500, chasing the highest return can mean taking on more volatility than you need in an account that you might need to access in such a short period of time.
The next element is risk tolerance. If it just makes you sweat and you can't sleep at night watching your account go from minus 18 one year to plus 15 the next, then regardless of what that end return may be, you can't suffer every day until you reach the finish line. There is value in some cases where if you save enough, putting yourself in a position where you have saved so much [00:06:00] that you don't have to have the highest returns to meet your objective.
You just need consistent returns to meet your objective.
And then lastly, sequence of return risk. Sequence of return risk is a phenomenon that shows that the order in which you receive certain returns can be incredibly important to the longevity of your funds.
An example would be if you have an investor who retires and start withdrawing money from their retirement accounts. And one investor starts withdrawing from an account that doesn't have negative returns for any of the first five years, but has all negative returns in the last five , years. their longevity is going to be significantly higher than that of an investor who has negative returns for the first five years and positive returns for the last five years.
The sequence in which you receive the returns matter. So if you have an extremely volatile account or a volatile index or an exchange traded fund, and you are currently withdrawing funds from that account, or you are on the precipice of withdrawing funds for things like retirement or other [00:07:00] income needs, it may not suit your objective to have such volatility in said account.
And a fourth phenomenon that we'll discuss after the break is the true diversification of that index fund, because I will give you a teaser. While many people see index funds and ETFs as incredibly diversified, I would argue that the opposite is what's really true. And for these investors, they often turn to an alternative, which would be utilizing an investment manager or an investment advisor, and they do this for a number of reasons.
Volatility would be a huge one. Having an investment strategy where that investment manager knows their goals, they know their risk tolerance, and they are seeking to take some of those large swings out of the market. You also have people, as we discussed in the last episode, who have big tax bills that they have due each and every year. So it's not just getting the return, it's how tax efficient you were in achieving that return. because I can attest, when you have a high income earner and they get to the end of the year and a non-qualified account, when they're talking to their investment [00:08:00] advisor or their cpa, they are just as concerned with the taxable impact of that investment as they are with the return that it received in the previous 12 months.
You also have investors who are attracted to this level of specialization because it allows them to cherry pick and remove or include certain accounts from their portfolio. An example would be an investor who's interested in E s G investing, environmental, social, and governance, where where they're wanting to make sure that the funds in which they invest don't run counter to their moral code.
And even aside from your moral code, you might have investment restrictions based on your employer. An example would be someone who works for Apple or LinkedIn or Netflix and their employment contract may directly forbid them from owning stock in the company with which they work. Another example would be if you work for an accounting firm or a consultancy like Ernst and Young, or Deloitte or Accenture, and they may say, not only can you not hold their stock, but you can't hold the stocks of any companies with which you've consulted.
So having a personalized investment strategy [00:09:00] allows you to whitelist those companies to make sure they're not included accidentally in your portfolio. After the break we'll tell you more about direct indexing and how it blends these two styles in a way that hopefully meets the objective of an investor who wants to manage taxes, remain diversified, while also having input on the values of the company with which they invest.
[00:10:00]
Brenton: The premise of direct indexing is this: you take an index like the s and p 500. And instead of acting like it does in an index or an exchange traded fund where you put your money in a basket and that algorithm invests in the entire index based on its appropriate weighting, direct index allows you to take that money and invest it individually in each of the companies that comprise that exchange.
So instead of having one fund where the shares of that fund dictate the value of [00:11:00] your investment, you have a pool of money that is individually investing and owning all 500 companies in this example. As a matter of fact, if you're following on screen, I'm reading from a promotional flyer about direct indexing from a company called Morningstar that says, owning individual stocks provides the potential to reflect the characteristics of an index, while at the same time offering ongoing tax lost harvesting, as well as increasing personalization aligned to their objectives. Now, tax lost harvesting is not something that we've named before, but we've talked about the concept of strategically taking losses in one area of your portfolio to offset the gains you've experienced in another element of your portfolio. That concept is called Tax Lost Harvesting. Taking an intentional loss to offset a gain so that it minimizes your tax burden.
There's another way that they describe this strategy in the PDF and it says, and I quote, tax Efficient Transitions and Gangs Realization deferral along with tax loss harvesting of [00:12:00] individual securities, which is just another word for stocks within the index, can give investors more opportunities to generate higher after tax returns.
The result of these tax efficient strategies is known as Tax alpha end quote. Alpha is another thing that we haven't covered in this podcast to this point, but the premise of Alpha, or another way to remember it is advisor added value. What financial tangible benefit am I getting by employing this strategy or this investment manager?
That I would not have gotten had I just plopped my money directly into the index. That is Alpha. Advisor added Value.
Now, there are several benefits to this, even above and beyond the tax mitigation. One of them would be the ability to cherry pick the stocks that run counter to the moral code.
Like we mentioned, for investors who are interested in ESG investing. For whatever reason, whether it's an employment concern or a moral hazard, you can go and instead of investing in all 500 companies in the s and p 500, you can [00:13:00] instead say, I want to cherry pick and invest in 475, but these 25, for reasons that are my own, need to be excluded from my current holdings.
But to me the biggest potential benefit of direct indexing as compared to an index fund is what we talked about before the break, or I alluded to before the break, the pursuit of a truly diversified portfolio as compared to what you currently see in indices like the s and p 500.
If you're following along on screen, and we're gonna put a link to all these articles in the show notes. There's an article from Market Watch that we're looking at that's entitled The s and p 500 is Ridiculous. Here's Why. And the byline says The index is effectively just a bet on a handful of stocks.'
We talked about how the s and p 500 is a market cap weighted index, and what that means is the companies that have the largest value of outstanding stock have a larger influence on the performance of that index than smaller companies with a lower market cap.
As an example, [00:14:00] the stock of Apple alone, that one company accounts for nearly 8% of the s and p 500 based on its weighting and market cap. That value and that influence is more than the bottom 200 companies in the s and p 500 combined.
But it gets worse if you extend it beyond Apple and you look at the stocks of Apple, Microsoft, Nvidia, and Alphabet, which is the parent company for Google. Those stocks represent 25% of the index weighting, which is not only bigger than the combined influence of the bottom 300 companies in the index, it approaches the influence of the bottom 400 companies.
And to me, not only is it dangerous to say that five companies alone have the collective impact of almost 400 other companies, it's also dangerous that when you look at all five of these companies, they are all in the same industry.
There is no diversification. They're not counterbalancing forces where when one goes up, the other may be going down. You have a significant portion [00:15:00] of your funds in what's supposed to be a diversified index that is on the backs of five companies that are directly connected to each other in terms of its economic impact, which is why in a year like last year where there were huge layoffs and huge economic instability in the tech industry, you have a year in the s and p like last year where it was down 18%.
So to me, one of the big opportunities in direct indexing is the ability to still own a portion of all 500 of those companies in this example, but to redistribute the weighting, so you are not as dependent on one industry or one sector. So you could say, even though the s and p 500 is weighted this way, I want to own all 500 companies, but I want you to redistribute some of the wealth from that tech sector and put those funds and put those risks more equitably across my portfolio so I can actually have that true diversification that I'm pursuing across all of my investments.
Now if all of this sounds like it's very pie in the sky, remember this is a [00:16:00] blend of the two styles. So you are paying an investment advisor for this strategy, which adds cost. You also, because you are individually owning all 500 of these companies in the example of the s and p 500, have to have a decent amount of funds to be able to achieve that objective, which is why I wouldn't be surprised if companies offering direct indexing said you have to have at least 50,000 or a hundred thousand dollars in an account in order to qualify for this strategy.
But if you're following all of our other tips and you're starting to establish those non-qualified investments, even if you don't have that money in your account now, at some point in time you will.
And when that time comes, the more you know about direct indexing, you can decide whether it might be that blend of a diversified market centric strategy that combines the elements of specialization that you find in investment management to form that perfect fit for your portfolio.
I'll see you next week.
[00:17:00]
