MARK RIEPE: As I'm recording this, there's a lot happening in the world of sports. The March Madness that is the NCAA basketball tournament is going on. The intensity of the NBA has ramped up as each team only has about 10 regular season games left to secure their spot in the playoffs. And spring training for baseball has started.
All this activity got me thinking about a cliche that has been used many times in different sports. The cliche is "addition by subtraction."
It refers to the process of making a team better by getting rid of players.
And not just any players, but star players, in the belief that while stars play well, they sometimes bring along negative baggage that more than offsets their eye-popping statistics.
The first reference that we found was by the former manager of the New York Yankees, Miller Huggins. He was disenchanted with one of his starting pitchers, Carl Mays.
Mays was a great pitcher. In fact, he's been referred to as the best pitcher not in the Hall of Fame. He started three World Series games for the Yankees in 1921 and won one of those games.
But increasingly Huggins was disenchanted with Mays. He started by dramatically reducing the number of innings Mays pitched, then Huggins refused eventually refused to play Mays at all, and eventually traded him. Huggins described it as a case of "addition by subtraction."
I'm Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab.
It's a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.
We'll get back to exactly why Huggins was disenchanted later, but baseball isn't the only sport where the "addition by subtraction" principle has been used to justify a counter-intuitive decision.
In 1989, the Dallas Cowboys of the National Football League traded Herschel Walker, one of the best running backs in the league. He was sent to the Minnesota Vikings along with three draft picks. In return, the Cowboys got four players and eight draft picks. Those draft picks were used to rebuild the Cowboys and resulted in three Super Bowl titles in the 1990s.
There's even a great example from women's college softball where a team suspended their star pitcher for violating a team rule and still managed to win the College World Series. This happened despite the fact that the team had only one pitcher left on their roster.
But enough sports talk, because what's more important is that the concept of "addition by subtraction" is a key component of an investment strategy that's been going mainstream.
In other words, we're going to look at one potential way you can add to your portfolio by getting rid of something using a method known as direct indexing.
And to help me with that is DJ Tierney.
DJ is a director and senior investment portfolio strategist for Schwab Asset Management.
He has over 25 years of experience in institutional sales, trading, and capital markets, with an extensive background in and knowledge of ETFs and fixed income. Before Schwab, he spent 16 years at Morgan Stanley, partnering with asset management firms in the roll-out and trading of ETFs.
MARK: DJ, thanks for being here today.
DJ TIERNEY: Thank you, Mark. It's a pleasure to join you.
MARK: So before we get into the details of direct indexing and what that's all about, maybe let's just start out with tell me a little bit more about your background. How did you get interested in a career in finance and, you know, money management?
DJ: Thanks. Yeah, I was not someone that was born and interested in this at a young age. I actually came into it indirectly in my mid-twenties. When I first became an investor, first got my 401(k) of my first post-college job, I got really interested in the markets and in investing, and, you know, found somebody that I knew in the business, did an informational interview, and he said, "If I were you, I'd go get an MBA at a top business school in the country and come back and interview with us." So I went back, I got an MBA in finance at UC Berkeley, specifically studying markets and investing, and, interestingly, joined that individual's firm, Salomon Brothers, and got my career started there.
In the middle of my career, I really migrated towards index investing. I decided it really fit so many different types of investors. So I've focused on index investing for most of the last decade.
MARK: Well, that's certainly been a big growth area, and I think contrary to a lot of the perception, indexing is also getting kind of more sophisticated, more complicated, solving more problems for investors. And, frankly, that's why you're here, to talk about a new variant called direct indexing. And I think for professional investors or maybe, you know, RIAs who may be listening, direct indexing is well known, but I suspect for most of our individual investor listeners, it's probably a new concept. So maybe let's just start at the beginning. What is direct indexing?
DJ: So I usually start my explanation of that answer by really emphasizing that it is indexed investing. And I don't always even presume that people understand what we mean by that. And I'll even start off by saying that there's been, really, a revolution in investing over the last 20 years, where indexed ETFs and index mutual funds have garnered a really big share of investment money in the markets. And that is because there's a lot of data that suggests it's a lower-cost, more-diverse way to get market exposure than the original alternative, actively managed funds. And so as the data has become compelling and costs have come down, more and more people are using index investing. So direct indexing is really an evolutionary step forward, we would argue, from ETFs and index mutual funds in that it can be even more tax-efficient and offer some personalization, and the first explanation, really, is it's direct ownership of the stocks. Rather than buying a share of a big, pooled investment like you do when you invest in an ETF or a mutual fund, when you own a direct-indexing account, you are the economic direct owner of hundreds of different shares of stocks. And it's that form of investing that is direct indexing.
MARK: Yeah, when you look at your brokerage account statement, if you own an ETF, you just see the name of the ETF on your statement. If you have a direct-indexing account, you see the individual component stocks, right?
DJ: Yes, you can. Yeah, on my account, and I should … full caveat, I'm an investor in a direct-indexing account. When I look at my account, I have a one-line item on my statement that shows the value of the account. But if I am curious, if I click through, I can see the hundreds of underlying securities. And I'll acknowledge straight up, for a lot of people that can be off-putting. You know, that sounds complicated. It kind of begs the question, "Well, why would I want to do that if I could just go buy one ticker and have an ETF that gives me similar exposure?" So worth noting that, and, you know, the answer is there's some really nice benefits to doing it—tax-efficiency, chance to personalize. And with technology we're making the experience of enrolling, investing, and monitoring it much easier.
MARK: Yeah, I think people sometimes forget that, you know, investment products, vehicles, and strategies, they come and go, but the successful ones really stick around because they're solving a real need for investors or fixing a problem in some way. You mentioned just a couple of them for direct indexing. So let's kind of go through a couple of those and starting out with tax-loss harvesting. Maybe explain for people how that works.
DJ: Sure. Sometimes it's easier to understand tax-loss harvesting if we even just step away from stock investing for a minute. It's common with a big commercial real estate investment portfolio that they'll do tax-loss harvesting. And in the real estate world, what that means is if you've got a big commercial real estate fund, you might be investing in properties in Austin, Texas, and in Chicago, and Atlanta. Well, different cycles hit different parts of the countries. So it might be that your Austin portfolio has tripled in value, and you've made huge profits in Austin. Maybe your Chicago portfolio has actually lost money. So a tax-loss harvesting opportunity example there would be you sell a couple of your Chicago properties, you realize a loss in your portfolio, and then maybe you simultaneously go out and buy different Chicago properties. So you keep your exposure consistent in Chicago, but you've realized an economic loss. That could be used to offset a gain you would have in Austin, Texas, properties.
So that's tax-loss harvesting. It's selling an asset that's down in value to lower your tax obligation intently versus one with a gain. And so in a stock portfolio that is a reality. If you invest in hundreds and hundreds of different stocks, your hope and expectation over the long haul is that many, even most, will go up. That's what we're seeking with stock investing. But the reality is some will go down. And so what tax-loss harvesting means in direct indexing is they're systematically monitoring and watching stocks that go down and asking the question, "Could we sell those, immediately reinvest the proceeds to stay invested neutrally in the market, but capture realized losses, which can be then used to lower tax obligations?" So that's kind of a complete answer to tax-loss harvesting.
MARK: Yeah, and I think we mentioned at the beginning this idea that you can actually improve something by sort of pruning … sometimes subtraction actually makes things better than continuously adding to that. Does that analogy work when it comes to the economic value added with tax-loss harvesting?
DJ: It does. It does, because if you tried to do this on your own, and there are investors that utilize tax-loss harvesting to be clear, but doing it … they might do it at a sector level, they might be invested in a fund that's gone down, but that act, selling something that's gone down in value, does run counter to human behavior. There is a bias in our composite that kind of runs against it. So, yes, by enrolling in this kind of strategy and handing that strategy to a professional management team and even utilizing technology to monitor it and do all that, it takes it off your plate, and can help overcome the bias that would prevent you from taking advantages of losses.
MARK: So tell me a little bit about … maybe expand on that and … is there a case to be made that by recognizing those losses and swapping out securities with, you know, ones you want to sell with ones that have kind of a similar exposure, what impact will that have on the returns for the investor over time?
DJ: Well, yeah, so the idea is really replicate that index. And the fact of the matter is it will cause, that act of tax-loss harvesting, will cause some deviation, but the data would suggest they can still stay in line. Where an ETF or an index mutual fund might be able to track an index within a 10th of 1%, a direct indexing account might be more like 1% or 2% variance over time. So you'll have some tracking difference, but the economic value that you can realize from those losses by reducing and deferring taxes, we think, will outweigh the deviation by an order of magnitude.
MARK: And that's where you get into this concept of most of us, you know, measure returns on a pre-tax basis, but when a tax-loss harvesting strategy is employed, it's really important to look at things on an after-tax basis. Is that right?
DJ: That's exactly right. And it's a key point. What we're trying to do is we're trying to stay very similar on a pre-tax basis, but beat on an after-tax basis. So, you know, we get that question, "Are you trying to beat the index?" And the answer is kind of differentiated. It's we're trying to just match it. This is index investing—we're just trying to deliver index returns—however, on an after-tax basis, have better returns than traditional index investing, i.e., ETFs and index mutual funds.
MARK: DJ, earlier you mentioned that you could certainly buy a pooled vehicle, like a mutual fund or an ETF, but to really unlock the advantages of direct indexing, you need your own dedicated account to this particular strategy. So could you spend some time explaining how a separately managed account differs from owning a mutual fund or an ETF directly?
DJ: Yes, I'd be happy to. And, you know, an ETF, boy, we've sure made it easy, right? You can pick up a smartphone, and if you know the ticker, you can buy an ETF in minutes. And it's easy. Commissions have come down. So we've made it very easy to access markets through traditional index investing.
The separately managed account is a slightly different experience. It's really … instead of investing, we would call enrolling in the strategy. And so you would work with an advisor, and really most direct-indexing accounts are offered through advisors. You have the discussion. They help you decide whether this the right fit for you. Do you have tax obligations that can be offset, and you enroll in it. You fund it with either cash or securities. And then once you're enrolled, you then have access to see the daily reporting, see the daily experience online. So it is a different experience, and there are … you know, it's a little bit more complicated in terms of tracking and tax filing at the end of the year, but what we're finding is that most investors have an understanding that the economic benefits far outweigh any of the differences in the experience.
MARK: Another one of the benefits you mentioned was this ability to customize or personalize your portfolio. So describe that in a little bit more detail. How can you make choices that are kind of unique to you as to how the portfolio will be managed?
DJ: And so there's a couple of reasons why people might want to do that. And to be clear, I've got an example of an investor in a Schwab ETF that I've been aware of for a couple years, because this investor makes requests of us every single year to calculate how much of the return in his ETF could be attributed to a tobacco company. This individual is really opposed to the tobacco industry. I believe that he lost a loved one in his life to tobacco-related illness. So every year we calculate as closely as we can how much of the income in his fund came from tobacco. And it's our understanding that he writes a check to an anti-smoking campaign for that amount to kind of offset his moral compass and his beliefs.
So that's the kind of lengths people are going to, to avoid having exposure in traditional index investing. So, with direct indexing, you can simply exclude companies, so that investor could have a very similar investing experience, but literally take out that tobacco company, take out tobacco companies to avoid that exposure. So that's what we mean by personalization. And sometimes personalized indexing is the synonym for direct indexing, by the way. So that would be one example, to align with your moral compass and your beliefs.
The other reason that comes up a lot is just existing concentration or exposures. You know, maybe you don't want to add and invest in the company that employs you or the industry that you work. And so that would be another application and a reason that you would want to personalize your index.
MARK: There are index mutual funds and ETFs on … I mean, there are thousands of indexes, and then there are tens of thousands of index funds and ETFs to track those indexes. So do you see the same kind of, I don't know if you would call it maybe market penetration with direct indexing at this point, or are the number of indexes, you know, more constrained to kind of the, you know, most popular ones?
DJ: Yeah, the first thing I would point out is that ETFs and index mutual funds have moved beyond just equities. And so there's bond ETFs, and bond mutual funds, and real estate trusts, and commodities, gold, those index strategies have really morphed beyond equities. Direct indexing really is firmly rooted in equities at this point, and there's a reason for that. To do that tax-loss harvesting exercise that we talked about, where you're looking for lots and lots of winners and losers, you need the diversified returns of hundreds of different companies. And that doesn't really exist in different asset classes. Bonds tend to move more uniformly, and so you wouldn't have the potential benefit in fixed income, and you wouldn't … certainly wouldn't have it in commodities that are more uniform in their movement.
So yes, it has grown, you know, over the last 20 years that direct indexing has been in place. I believe that the number of index choices has certainly increased. You can have your U.S. large cap, U.S. small cap, you can have international developed. So it's growing in its place inside the equity investment world, but it is rooted in equity investing.
MARK: Yeah, so best to think of it as a strategy for those sort of core holdings in your portfolios.
DJ: Exactly. And if I haven't mentioned it already, taxable, right? Since the main benefit is taxable, that really is a … most providers won't allow it in a tax-qualified account like a 401(k) or an IRA because the big economic benefit is that tax efficiency.
MARK: DJ, you just mentioned the fact that direct indexing has been around in some form for 20 years. So why is it now that it's becoming a lot more available to individual investors? What's been going on that has that has triggered that?
DJ: Yeah, that's a great question because sometimes we describe it as new, and then we'll say it's been around for 20 years, and those two things are at odds. And so the example of it being around for 20 years, there are at least two providers that have been offering this for over 20 years. But the catch is they were offering it with really high account minimums, and, really, it was a strategy for the ultra-high net worth. So when direct indexing started, account minimums were over millions of dollars, $5 million account minimum, a million-dollar account minimum to enter the strategy. And that's because the costs to utilize the strategy were high. And so to get the economic benefit to match all the costs … and by the way, the fees on it were, you know, over 1%. And so it … really, you needed to be at a high tax bracket and a high wealth level for it to be a viable strategy.
And now things have changed. Commission-free trading, the ability for scaled computing to do these portfolio optimizations every single day, a lot of the costs have come down, and so a greater number of providers have entered the space. Account minimums have come down to be a fraction of what they were. And so the bottom line is that for millions of U.S. investors, this is now a viable strategy because of the account minimums and the lower costs. It makes sense for them. And so for them it is new.
And to your point earlier, if you polled a hundred investors in America right now, less than 10% of them would have heard or understood what direct indexing is. So there's a big opportunity for us to help educate people that this opportunity has been around, there's results that it's been working for a long time, and now it could be a viable strategy for kind of the mass affluent American investors.
MARK: Yeah. And, DJ, you mentioned costs there, and, you know, to generalize across the industry, it seems as if most of those costs have been … those cost savings have been passed on to the account holder, in the sense that a direct index-indexing strategy will tend to be more expensive than an index fund, but far less expensive than your typical actively managed fund. Is that right?
DJ: Yeah, that's correct. Yeah, the cost and expense ratios for a direct-indexing account will lie somewhere in the middle between an ultra-low-cost index ETF and an actively managed fund. It's going to be between those. And then the trend is the investor's friend—costs are coming down in the last couple years. So that's the advantage and the opportunity for investors to learn about this now.
MARK: DJ Tierney is a director and senior investment portfolio strategist for Schwab Asset Management. DJ, thanks for being here today.
DJ: Thanks so much for having me, Mark.
MARK: To sum up, direct indexing is a way of opening an account and then buying the stocks that replicate an index. You own the individual stocks directly instead of owning shares in a collective vehicle like a mutual fund or ETF that tracks that same index.
So why do this? Well, you can use tax-loss harvesting by selling stocks whose prices fall below your purchase price and replacing them with stocks that are similar enough so that you still track the index pretty closely. You can then use the losses to offset gains in the rest of your portfolio.
Essentially what you're doing is trimming losers and replacing them. You can also exclude stocks that are in the index that you already own in the rest of your portfolio so that you don't get over-concentrated.
Finally, DJ also talked about the personalization aspect of direct indexing, how you can exclude companies that don't reflect your values and beliefs. And that ability to personalize or to customize is important. We've done episodes in the past on how you shouldn't automatically accept the default setting on an investment plan, as it may not reflect your unique situation. That's intuitive to most people.
Last year Schwab conducted a survey of investors, and one of the main themes of the results was that people generally wanted more personalized options when choosing their investments.
Almost three-quarters of Americans say their personal values guide how they make life decisions more today than they did three years ago.
69% say that supporting causes they care most about are a top consideration when it comes to their financial decisions.
Direct indexing is just one way that people are starting to exercise greater and greater control over the individual investments in their account.
That doesn't mean direct indexing is right for everyone. DJ highlighted a few areas that might work for certain types of investors. For one, if you are looking for ways to offset gains in your portfolio, harvesting losses can help.
The other area is the extent to which you value personalization.
According to the Modern Wealth Survey Schwab did in 2022, 82% of Americans agree that their personal values play an important role in how they manage their finances.
So to learn more about personalized indexing strategies, check out Schwab.com/DirectIndexing.
Before I circle back to Carl Mays and why Miller Huggins disliked him, I want to first thank you for listening. If you've enjoyed the show, please leave us a rating or review on Apple Podcasts.
And if you know someone who might like the show, please tell them about it and how they can also follow us for free in their favorite podcasting app.
You can also follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.
Back to Carl Mays. He was certainly a complicated person. Before the Yankees, he pitched for the Red Sox. He was an amazing pitcher for them as well and led them to winning two World Series in three years.
But he was also what today we would call a diva. In fact, his relationship with the Red Sox was so cantankerous that he left the team and refused to play for them, forcing a trade to the Yankees.
Today that kind of behavior happens all the time in professional sports leagues, but back then it was revolutionary.
The downward spiral in his relationship with the Yankees started in 1920 when Mays threw a pitch that hit Cleveland shortstop Ray Chapman in the head and Chapman died 12 hours later.
That incident, plus unsubstantiated rumors of gambling on games, spelled the end for Mays and his time with the Yankees.
We've also talked about the "fresh-start effect" on past episodes of this show, and when Mays went to Cincinnati, he got that fresh start, and he was terrific again for a few seasons before age finally caught up to him.
That's it for Carl Mays, and that's it for us. We'll be back again in a few weeks with our final show for Season 13.
