An Update to Our Direct Indexing Program

In a comprehensive update on their direct indexing model, the team highlights its success over the past two years, focusing on achieving index-like returns while enhancing tax efficiency through strategic selling of underperforming companies and smart reinvestments. They detail the creation of a 2% tax alpha in 2023 through capital losses, which can be used to offset future gains in diverse portfolios. Additionally, they emphasize a strategic shift in asset allocation for 2024, moving towards large-cap investments due to their resilience in high-interest rate environments and reducing exposure to mid and small-cap companies. The update also covers international investment strategies, including a more selective approach to company selection and excluding China from their emerging market ETF due to economic and political concerns. They encourage communication for further clarifications and anticipate completing these adjustments by the second quarter of 2024.

Video Transcript

Welcome, everyone. Excited to give you a quick update on our direct indexing model. So we’ve been doing this now for over two years. And so one of the great benefits of direct indexing, obviously, we are tracking index like returns, but also taking advantage of the companies that don’t do well inside the index, selling those at a loss, repurchasing something immediately, making sure we don’t go back to the original companies in 30 days. And magically we have the same returns as index, but also tax efficiencies that we can use to offset future gains in your stock portfolio or also elsewhere. If you have a real estate transaction and a gain, or a private business or a private investment, those losses will offset the taxes on those gains. So were able to do this very effectively in 2023.


Market was great, but were also able to create between a 2% tax alpha when looking at the capital losses generated. So with that being said, these losses were communicating with your CPA. They get carried forward. So the first thing you can do is you deduct up to $3,000 of income per year off of your ordinary income, and then the rest of the losses get carried forward with you for the rest of your life. Now, we can get to tax efficiency one of two ways. One, we can step up basis, and so that way when you do go to unwind this money, you have, all that basis is going to come out tax free, or we can save those losses for the future. So our philosophy is we do want to step up basis when we can along the way.


Because once you do that, you’ve solidified yourself against any tax law changes in the future due to we’re in an election year, we’re not anticipating any tax law changes and loss carry forwards. But it’s always smart to step that up and guarantee that tax free nature of your basis in the future. So we are going to be stepping up basis on some of the losses that we’ve carried forward from 2023. As a proactive move, we’re also going to use this to shift some of our asset allocation assumptions. So one of those is going heavier into large cap versus our mid cap and small cap. And the rationale for that is because companies with strong balance sheets have the ability to navigate the higher interest rate environment we’re in versus a smaller mid cap company that doesn’t have as strong of a balance sheet.


They’re not going to weather these high interest rates. And a lot of small companies we’ve seen are becoming very cash strapped. You’re cash strapped. You’re really reliant on other sources or banks, loans that can charge essentially double what they were a couple of years ago. So heavier into large cap, also international. So James and Ben chip in here, but 49% of the overall in the world, 49% of the population will be out to vote this year. So there’s going to be a lot of political turnover. International space. We are also limiting the companies from over 2000 companies that we can purchase in the software down to about just under 400. And those 400 are going to have a couple of focuses to us. So James, can you speak to that?


Yeah, we’re going to shift into quality companies. So larger companies, cash on the balance sheet, low debt. I think it’s really interesting. If you look at the last twelve months of the stock market in the US, it’s been seven companies that’s carried primarily the whole US stock market, the seven tech companies internationally. That hasn’t necessarily happened as much. And so a lot of international economies and markets are still down. We haven’t seen that huge rebound. So we’re not predicting any type of recession or anything. But if there is volatility through the election and continued high interest rate environment, just like you said, small companies have a hard time raising money right now. It’s harder for them to get money from a bank. We’re just going to shift more in quality companies that no matter what happens, they’ll be able to weather the storm.


Absolutely. And then the last move we’re making with the emerging markets, this is the one place inside of the direct index portfolio that we still use an ETF, just because a lot of the companies in emerging markets don’t have enough trade flow to make those trades effectively. So we use a broad ETF, very low cost ETF, emerging markets, we’re shifting that to exclude one country. So Ben, can you give us a little insight on that?


Yeah, the ETF is going to exclude China. And the reason being is that essentially, think about the housing market in 2008 in the United States, it had gotten to a point where it was in a bubble and it basically burst. China is either approaching that or very close to exceeding that. So we just want to make sure that in our international space, like Jameson said, we’re working with companies that have strong balance sheets in that developed space, but in the emerging space we’re not including China.


Yeah, actually I heard a statistic, they’re triple over levered than what the US was before the 2008 financial Cris, the housing bubble.


I think too politically there’s a lot of tensions just with China. And so there could be, I’m terribly speculating here, sanctions or a war, something that could affect as well.


Yeah, absolutely. Well, those are updates. So expect, obviously, if you log in with tax loss harvesting, looking for tax loss harvesting opportunities every week you see those moves on a pretty consistent basis. But there’s going to be a lot more moves that you see in the next couple of months as we’re working through accounts, one by one, a proactively stepping up basis and using part of the losses from last year, and then also utilizing those losses last year to realize some gains, but also tactically shift into higher large cap exposure in the US, lower mid cap small cap exposure in the US and then also shifting to that quality based factor investing that Jameson explained in the international space. And then also, though, shifting to the ETF, that’s going to exclude China on the emerging market space.


So please reach out if you have any questions. And we look forward to completing these changes within the quarter two time frame of 2024 and look forward to also reviewing this one one during your next review.

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