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Direct Indexing: Personalized Portfolios for Physicians?

Recently, I held a webinar with Bill Martin from Forme Financial on common financial pitfalls for doctors and what we can do about them. One of the more interesting concepts that we discussed was direct indexing.

It generated a lot of questions. So I asked Bill for help putting together this guide to direct indexing!

Direct indexing for physicians

As physicians, we typically pay a lot in income taxes and have distinct financial goals. And our portfolios should reflect this reality. Yet, as we know, many commonly used investment strategies (many of which I don’t recommend, like actively managed funds) do not optimally minimize taxes or allow for personalization.

direct indexing

For example, active mutual funds are inherently tax inefficient due to additional fees and associated taxes from frequent trading. But even in passively managed index funds, investors inherit the embedded gains of the funds at the time of purchase. And mutual funds must distribute 98% of their calendar year income to shareholders. Such distributions translate into a tax hit for investors even if a fund generates an investment loss. This is a potential disadvantage for physicians who already pay a lot in taxes.

Also, exchange traded funds (ETFs), another popular investment type, have certain limitations for investors requiring enhanced customization. Since ETFs pool investors’ money into a basket of securities, portfolio personalization – including the choice of which underlying securities to own – is limited.

For instance, if a physician did not want to own weapon manufacturers in their portfolio or preferred owning stocks with modern governance policies, ETFs that track broad market indices do not allow for this level of personalization.

When evaluating typical physician portfolios, we often find generic, one-size-fits-all investments that don’t account for the complexity of physicians’ financial circumstances

Furthermore, even “personalized” portfolios are usually clones of other strategies with only small tweaks. They typically don’t reflect the individual goals, tax rates, career considerations, and other factors distinct to each physician. Personalized portfolios should be customized based on these details, and managed efficiently and cost effectively through modern technology. These attributes are at the heart of direct indexing and what makes this form of investing truly a personalized experience for each physician.

Related Post:
Comparing Index Funds and ETFs: What You Need to Know

What is direct indexing?

Despite the wide-spread adoption of mutual funds and ETFs, direct indexing can enhance tax efficiency and portfolio customization.

Direct indexing is a portfolio strategy that uses individual stocks to track the risk and return profile of a specific index such as the S&P 500 Index*. In contrast to investing in just few, select individual stocks, with direct indexing you directly own all—or a subset of the underlying securities—of an index. This approach allows for better personalization of portfolios designed to meet the unique financial needs of physicians like you.

Plus, direct indexing may generate better after-tax performance than comparable mutual funds and ETFs by 1% or more annually. Such outperformance potential could translate into significant additional wealth creation for physicians over their career.

Related Post:
5 Reasons Index Fund Investing is Better than Stock Picking

Direct indexing has historically been available institutional investors. However, this strategy is becoming more mainstream.

Cerulli Associates, a research and consulting firm, reported in 2021 that they expect direct indexing to grow at an annualized rate of over 12% over the next five years. This is faster than both mutual funds and ETFs.

Benefits of direct indexing

Direct indexing, combined with advanced portfolio management technology, offers the following benefits for physicians:

Personalized Portfolios

We will use Forme Financial as an example since we can get an inside look at their technology that allows for direct indexing. There, client portfolios are constructed using sophisticated optimization technology designed to replicate the exposures of an underlying asset class or investment style.

The optimizer uses a complex mathematical process to solve for the best possible portfolio. This is based upon client-specific requirements like capital gains budgets, existing holdings, and security restrictions.

The result of this portfolio construction process is a customized portfolio composed of individual equity securities designed to track a specific index, while accounting for a physician’s unique tax considerations.

In contrast, traditional investment strategies such as mutual funds and ETFs lack end-investor control and full transparency. Thus, it’s hard to know exactly what you own in these funds that tend to have unclear investment mandates.

Again, my recommendation if using the direct indexing strategy would be to track a broad, total market index.

Enhanced Tax Efficiency

Through direct ownership of the underlying securities, direct indexing allows investors and their advisors to be in control of when they realize gains and losses. Such control is often not the case when investing in index funds alone given their annual capital gain distribution requirements. 

Tax loss harvesting

Because of better control, direct indexing provides more opportunities for tax loss harvesting. Tax loss harvesting is a strategy of selling securities at loss to offset capital gains tax.

These opportunities to save on taxes arise because certain underlying stocks of the tracked index may be trading at a loss even if the overall index has posted a gain.

ETFs and mutual funds trade in baskets of securities rather than by their underlying holdings. This limits tax loss harvesting for these pooled investment vehicles. Concurrent to tax loss harvesting, you need to buy replacement securities (that avoid wash sale violations) to stay invested in the market according to your index and asset allocation. 

Conversely, direct indexing holds more securities that inherently have more variability than a single investment position of a fund. The raw number of securities mathematically creates more opportunities to harvest losses with direct indexing.

If capital losses exceed gains in any given year, you can use them to offset up to $3,000 of ordinary income per year. What is less widely known by physicians is that you can apply capital losses against capital gains in future years on federal tax returns for the remainder of one’s lifetime. You can use these losses to offset gains in an investment portfolio. You can also offset gains from the sale of other assets with capital gains. This can include the sale of real estate or a physician practice.

It is important to proactively tax loss harvest throughout the year, rather than just at year-end. For example, in 2020, the market sharply dropped in March, April, and May in response to COVID. However, by year end, the market had posted double-digit gains. Investors who waited to sell their losses in November and December missed out on significant tax loss harvesting opportunities. 

Integration of legacy holdings

Additionally, direct indexing allows for the tax-efficient integration of legacy holdings when transitioning portfolios to this strategy.

By incorporating investors’ existing holdings with low cost bases, direct indexing can avoid realizing unnecessary capital gains when transitioning portfolios. Holding legacy positions may be tax efficient. However, this approach can result in portfolio drift from the investor’s target objective over time.

To help manage this risk without incurring a large, initial tax bill, Forme Financial uses smart technology to automatically transition a portfolio over multiple calendar years to defer tax liabilities into future years. This incorporates a client’s specific capital gains budget. This way, investors can specify a threshold for how much in capital gains they are willing to realize during a given calendar year. 

Because of better control, more opportunities for tax loss harvesting, and the opportunity to transition portfolios tax efficiently, direct indexing can generate better after-tax performance than comparable ETFs, mutual funds, and market indices.

According to a study published in the CFA Journal**, tax loss harvesting can generate 108 basis points (1.08%) of annual tax savings.

When combined with other tax-smart investing strategies such as asset location and tax-efficient withdrawal optimization, aggregate annual tax savings can be up to 2% or more each year.

Such savings compounded over multiple years can translate into significant wealth for physicians.

direct indexing

Environmental, Social, and Governance (ESG) Investing

ESG investing incorporates investment holdings that score highly on a client’s preferred environmental, social and governance factors. Incorporating ESG criteria into portfolios is an increasingly popular way for clients to align their values with their investments.

Yet, ETFs and mutual funds don’t enable investors to specify which stocks to own. Instead, investors hold the entire basket of stocks in these funds.

Direct indexing, in contrast, allows investors to choose which stocks to own and which ones to avoid. Accordingly, direct indexing lets physicians steer clear of stocks that don’t align with their values. For example, if a physician doesn’t want to invest in gun stocks, they don’t have to.

As ESG investing continues to gain broader market acceptance, a growing number of investors integrate ESG factors. Despite having more access to these types of ESG options, physicians may have unique social preferences that differ from the ESG factors of any given mutual fund or ETF.

Direct indexing allows physicians to restrict exposure to certain securities and industries. This enables the construction of truly personalized portfolios that uniquely reflect their ESG values.

Low Cost

Keeping investment costs low is a prudent strategy (see what we did there??) to help physicians reach the financial outcomes they desire. Markets are not controllable or predictable.

However, investment expenses are a known factor. Minimizing these costs increases the probability of investment success. This well-researched fact has contributed to the popularity of passive investing with index funds and ETFs.

Direct indexing may be the next evolution of low-cost investing. That’s why Forme Financial uses it to create bespoke portfolios using direct indexing. And they can do this with pricing that is competitive with passive mutual funds and ETFs.

Direct Indexing Isn’t for Everyone

Not every physician needs to invest in a direct indexing strategy, especially those who have not accumulated many taxable assets yet.

For example, if a resident, fellow, or early practicing physician may have the majority of their financial assets in retirement accounts that are tax deferred or tax free. This is the case for me. Most of my investments are in tax advantaged accounts like my 403b. And you can see an in depth review of my 403b here. In this case, direct indexing with its associated tax benefits does not make sense. In such cases, ETFs and mutual funds are likely the more appropriate investment vehicles.

Generally, direct indexing is a better fit for high net worth physicians who have taxable assets and are in higher tax brackets.

At Forme Financial, the investment minimum for direct indexing is $100,000 in non-retirement accounts. And typically investors in these types of accounts have income levels of $250,000 or more – like most doctors.

Should You Consider Direct Indexing?

According to Medscape’s 2022 Physicians and Taxes report, doctors pay on average nearly $100,000 in federal, state, and local taxes. Furthermore, the study found that the median physician marginal tax bracket was 35% in 2021, the second highest income tax bracket. If you find yourself near these averages or above, have taxable assets, and are looking for ways to lower your tax bill, direct indexing may be an investment strategy for you to consider. 

And here are some other resources to help doctors looking to optimize their tax strategy:

Owning securities directly affords you better control of when gains are realized. It also provides more opportunities for year-round tax loss harvesting. These tax savings allow you to keep more of what you earn with more of your money remaining invested to help reach your financial goals. Combining this with the even more important benefits of passive investing via direct indexing can be a win-win. Direct indexing is also often a good fit for investors interested in aligning their portfolios with their values.

If direct indexing seems like a potential fit for you, you can learn more by reaching out to Forme Financial for education here.

And you can learn more about stock market investing for doctors with these resources:

What do you think? Have you heard of direct indexing? What concerns do you have about it? Could it be right for you? Let me know in the comments below!


*The S&P 500 Index is an unmanaged index containing common stocks of 500 industrial, transportation, utility and financial companies, regarded as generally representative of the U.S. stock market. The index reflects the reinvestment of dividends, if any, and capital gain distributions, if any, but does not reflect fees, brokerage commissions, or other expenses of investing. This index is used for comparison purposes. It is not possible to invest in an index.

** Source: https://www.cfainstitute.org/en/research/financial-analysts-journal/2020/empirical-evaluation-tax-loss-harvesting-alpha)

General Disclaimer

This presentation contains general information that is not suitable for everyone and was prepared for informational purposes only.  Nothing contained herein should be construed as a solicitation to buy or sell any security or as an offer to provide investment advice. Forme Financial is a registered investment adviser. For additional information about Forme Financial, including its services and fees, send for the firm’s disclosure brochure using the contact information contained herein or visit https://adviserinfo.sec.gov.

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    Jordan Frey MD, a plastic surgeon in Buffalo, NY, is one of the fastest-growing physician finance bloggers in the world. See how he went from financially clueless to increasing his net worth by $1M in 1 year and how you can do the same! Feel free to send Jordan a message at [email protected]

    2 thoughts on “Direct Indexing: Personalized Portfolios for Physicians?”

    1. great post man! the one problem with the tax loss harvesting feature of direct indexing is becoming “locked in” as mentioned by FI physician. not sure if this is a real problem or not as he says from a post:

      “Becoming Locked In-
      Eventually, after about ten years, you will have nothing but gains in your account and thus will no longer be able to tax loss harvest. At that point, you have 80-200 individual positions you need to manage instead of 2-6 ETFs.

      Complexity when Locked In-
      And this complexity is a massive downside. Eventually, you will be locked into your portfolio. By “locked-in,” you will have painful, significant embedded capital gains that you need to recognize if you wish to use the money before dying and getting a step-up in basis.

      Instead of having 2-6 ETF positions, you might have 150 individual equity positions. That’s a lot of decisions that need to be made and a lot of complexity for the older you!”

      is this a big knock against direct indexing for TLH purposes? or is it just theroretical and really doesn’t happen?

      Reply
      • Hey Rikki! I do agree this is a potential downside. I think that’s why direct indexing is not a DIY endeavor but better handle by computer algorithms available in commercial programs. In the end I think one has to determine if this added complexity is worth it for them…in a lot of cases the answer may be that it’s not but for some it might be!

        Reply

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