Power Up Wealth podcast – Episode 114 – Direct Indexing: Tax Efficiency for the Modern Investor
James Derrick 0:00
Are you sitting on large capital gains from investments in a business or the stock market? Technology is now making it possible for more investors to take advantage of an investment strategy that was once only available to the ultra-affluent. I’m James Derrick, President of Smedley Financial. Today we will be talking with expert and guest Mikal Aune about direct indexing.
Shane Thomas 0:26
Welcome to the SFS Power Up Wealth podcast, where we provide impactful insight and expert opinions on timeless financial principles and timely investment topics, preparing you to make smarter decisions with your money.
James Derrick 0:42
Mikal, thank you for joining me today.
Mikal Aune 0:44
Glad to be here, James.
James Derrick 0:45
Mikal Aune is the Executive Vice President of Smedley Financial. He has a Certified Financial Planning designation and a Certified Private Wealth Advisor designation. He’s done an incredible amount of research on direct indexing. Mikal, let’s start out with a quote. Arthur Godfrey: “I’m proud to pay taxes in the United States. I could be just as proud for half the money.” This is the sentiment that I believe nearly everyone agrees with.
Mikal Aune 1:13
Yes, because we’re proud to live in the United States, we’re proud to pay taxes here, but we also worry about what the waste is, and it’s if you can pay half as much and still get a good bang for your buck on tax dollars, we’d love to pay less in taxes.
James Derrick 1:27
And this is exactly what direct indexing attempts to do. What would you explain who is it right for?
Mikal Aune 1:33
It’s right for somebody that has a lot of gains, either through they’ve invested in the stock market and their portfolio, their, I should say, their non-retirement portfolio has grown a lot. So this isn’t right for money that you have inside of a 401(k) or an IRA, because taxes don’t matter inside of those. You’re only taxed on what you pull out. So this is non-retirement money that is really important for that. It’s really important for somebody that has a large stock portfolio, like you’ve received restricted stock units or stock options through your company, and you have a lot of money sitting in one company stock, and it’s also right for business owners that are planning to sell their business in five years or so, because you need some time to build up losses in order to help offset gains that you might have in the business. So, those are three major cases, or use cases, people that could use direct indexing.
James Derrick 2:21
One of the things that you told me before we began is that scale matters as well. Could you explain what that means?
Mikal Aune 2:28
In direct indexing, the idea is I still want to get a good return, that’s like the stock market, because a lot of times you hear, I want to realize losses someplace to be able to offset gains somewhere else. Well, the problem is, if I have losses, that means I lost money on something, and so I can do a lot of tax planning that gets you losses, but does that mean I really don’t get a good return? So there’s a balance to say, how do I get a good return and get losses at the same time, which almost sounds too good to be true, like how do I make money and you know lose money at the same time. So direct indexing is saying I’m going to take money and I’m going to get gains with some of it and try to track an index like the S&P 500, and if I can track that index really closely, but at the same time generate losses, then I could use those losses to offset the gains, either in that structure or gains that you may have from the sell of a business, or I’m holding company stock, and I feel trapped in the company stock, and I don’t know how to get out without paying a ton in taxes. Well, here’s a way where you can intentionally generate losses while still getting a good return and be able to offset taxes somewhere else.
James Derrick 3:34
Okay, so we’ve got the, for example, the S&P 500, which is made up of 500 stocks, and if somebody has a direct indexing portfolio, it may mimic that index or another index, and so it’s going to buy up 500 stocks, maybe a little bit less.
Mikal Aune 3:50
The direct index is probably going to buy more like 200 to 300 but it’s going to buy enough of them that it’s going to mimic the S&P 500, because you know that the S&P 500 is get is cap weighted, which is, we’re getting a little into the weeds here, but a cap weighting is a company like Apple is going to have a much larger weighting than one of the small ones, you know, that’s, you know, stock number 499.
James Derrick 4:11
Bigger companies, more important, that’s how the indexes work. So people buy up into hundreds of stocks in order to try to stay close to the index, but they’re not exactly the same, and then things are going to fluctuate from there.
Mikal Aune 4:25
Yeah, so there they call it a tracking error, and so a tracking error is, hey, the S&P 500 has a return of 17%. Well, their tracking error keeps them within plus or minus 1% so if the S&P 500 returns 17% then this would return either 18 or 16, or somewhere in between those two, so it’s going to be close, but it’s not going to be exact, because you’re not holding all 500 and some of that’s by design, because what you’re trying to do is say in any given year, as the stocks are going along, there’s going to be some of them that gain really good, and at any given point in the year, there’s some that are going to be down, because by definition the S&P 500 is just an average of those 500 stocks. So, what direct indexing does is say if we have a bunch of them that are down, we’re going to sell those out, and we’re going to replace them. So, like I said, it’s only holding 200 to 300 stocks of the 500 so we sell off some of them, and replace them with others that have a similar profile.
James Derrick 5:23
So, the example you gave me before, I think, would be helpful here, where you said, “What if the investment owned Coke and Coke went down, but it didn’t own Pepsi? Well, you could sell Coke for a loss, and then buy Pepsi, and in theory, they might be similar returns, and so then going forward, you still continue to be similar to the index, but you were able to capture the loss when you sold Coke.
Mikal Aune 5:49
Yes, and why it’s important to sell Coke and buy Pepsi is because of wash sale rules. So, if I sell Coke at a loss and I buy back Coke within 30 days, the IRS negates that loss and just says it’s a wash sale, and so they say, in essence, you didn’t sell Coke, and so that’s why you have to sell Coke and buy Pepsi, is so that you avoid that wash sale rule.
James Derrick 6:11
And then whatever happens the next day, your portfolio should still be somewhat close to the index because you still have similar risk factors.
Mikal Aune 6:20
Yes
James Derrick 6:20
Or similar investments.
Mikal Aune 6:22
And the other importance of owning an individual stock is you’re the one that can benefit from the individual gains or the individual losses, because a lot of people have talked about buying an index fund. So an index fund, there’s a bunch of them out there that will track the S&P 500 or other indices that are out there, like the NASDAQ, because you can’t buy the S&P 500 directly or the NASDAQ directly, but you can buy funds that mimic those. The difference is inside of those funds, they keep the losses, they mitigate them or put them against the gains, but that happens all inside of the ETF. So I don’t pass through or receive any of the losses from that individual index fund, and that’s one thing that’s really important to know, is hey, if I go out as an individual investor, I just want to buy some of the tracks of the index. It’s really easy to find an index fund that does that, but I don’t get to participate in any of the losses, I just get gains. So, like last year, for example, so 2025 the S&P 500 returned 17%. At the end of the year I look at it and I got 17% because I’m mimicking what the S&P 500 does if I’m holding an index fund. The only thing is in the middle of the year it had an, the S&P 500, had an 18% drop, so there is a whole bunch of losses that a direct index can harvest when the market has hiccups, or if there are stocks that are down during the year and you get to take those losses because you hold the individual stock.
James Derrick 7:44
If you sold them when they were down.
Mikal Aune 7:46
Uh, huh, that’s why you hire a direct index manager, because the direct index is going to be able to manage that for you and sell them at an appropriate time. If you’re holding the ETF, that tracks an index fund, so either an ETF or a mutual fund that’s just an index fund, and I know we’re kind of splitting hairs between there’s an index fund versus a direct index, but an index fund that’s just tracking the S&P 500, I can kind of watch it, and if the whole index is down, then I can try to sell it, but I have to be watching it all the time. I need the whole index to go down in order to realize a loss. If I have a direct index where I have a manager watching it for me, I’m holding individual stocks, and at any given point they can say, “Hey, Coke is down, and they’re down big. We’re going to sell off Coke, and we’re going to buy Pepsi. We don’t have to wait for there to be a big recession where the whole S&P 500 loses 10%.
James Derrick 8:32
This is a compelling argument. Let me ask this question: Why now? Has technology changed so much that this is possible when it wasn’t before?
Mikal Aune 8:40
Yes, direct indexing has been around since the 90s, but it was only done for the ultra-affluent, and then it moved down to the affluent, and now we’re getting to the mass affluent that can do this because of technology. They’re able to trade more efficiently. The trading costs have come down astronomically, so you know, inside of the actual fund, as they trade, they’re paying like two cents a share to trade these things, where before you’re paying seven bucks or 35 bucks a trade, and it just wasn’t economical for the masses.
James Derrick 9:10
When I started in this industry, people were paying hundreds of dollars per trade.
Mikal Aune 9:14
Yeah, per trade.
James Derrick 9:15
It’s changed a lot in terms of pricing as well as technology. I mean, it’s this strategy really is far more possible than before, but the scale matters, as you mentioned earlier. And so, what dollar amount do I really need to have in order to make this worth it?
Mikal Aune 9:29
It depends on what you’re trying to offset. So, you know, some people are like, oh, you can put in a few thousand dollars in here, but as a general rule, and there’s no hard, fast rule, because there can be years where there are a lot of losses, and there can be years where there aren’t any losses at all. I mean, it’s going to vary. They say on average it’s about 4% that you’re going to realize in losses. So, I’m going to track the S&P 500 for good or bad. If the market goes up 17, I get that. If the market goes down 17, I get that too.
James Derrick 9:55
Something similar?
Mikal Aune 9:56
Yes, I get something similar to S&P 500, but if it goes down that also means I can sell at a loss, and I can use those losses to offset somewhere else, and I think that’s why scale matters, is because if I have, you know, a non-retirement portfolio of a million dollars that I’m sitting on, let’s say $300,000 in gains. Well, if I put in $100,000 into a direct index, I’m going to realize about $4,000 in losses. Well, it’s going to take me a long time to offset the $300,000 in gains at $4,000 in losses. So the scale matters, and you have to have enough that you put into the direct index. There are a lot of these direct indexing companies and the managers where the minimums are $100,000 or $250,000, so it does require scale to get into these investments, and but you also need scale to offset the kind of tax burden that you’re looking to offset.
James Derrick 10:47
I think we’re going to have you come back and talk about this again. So, let me just ask one final question, which is, what is the role of a financial advisor in helping with this, because this is a little more sophisticated than some of the things that I hear people do on their own?
Mikal Aune 11:01
So one of the our big roles is that we’re not tax advisors, we’re not going to give you tax advice, but we are tax planners. We can help you create the plan to go around this to say, all right, I need to get out of company stock. How do I do this over time in a tax efficient way so I don’t get killed on taxes? Or I’m a business owner, how do I plan this and say I want to exit in five years, and I want to build up losses, because that’s one of the great things about direct indexing, is if I have losses that I don’t use in any given year, I can carry them forward to the next year and build the nest to where I sell my business in year five, and now I can offset some of my business gains and not have so much in tax. So we’re the planners, we’re going to help you create a plan for the future, and we’re expert tax planners. There are a lot of financial advisors out there that do very little with tax planning, and they don’t know a lot about your taxes, and they don’t get into the intricacies of taxes. So we’re really there to help you create the plan, the whole financial plan, and make sure that your taxes are going along well with it.
James Derrick 12:01
Mikal. Thank you so much for coming in to explain this to us. It sounds like a real opportunity.
Mikal Aune 12:06
Thank you, James.
Shane Thomas 12:11
Thank you for joining the Power Up Wealth podcast. Smedley Financial is located at 102 S 200 E Ste 100 in Salt Lake City, UT 84111. Call us today at 800-748-4788. You can also find us on the web at Smedleyfinancial.com, Facebook, Instagram, Twitter, and LinkedIn. The views expressed are Smedley Financials and should not be construed directly or indirectly as an offer to buy or sell any securities or services mentioned herein. Investing is subject to risks, including loss of principal invested. Past performance is not a guarantee of future results. No strategy can assure a profit nor protect against loss. Please note that individual situations can vary. Therefore, the information should only be relied upon when coordinated with individual professional advice. Securities offered through Osaic Wealth, Inc., member FINRA/SIPC. Investment advisory services offered through Smedley Financial Services, Inc.® Osaic Wealth is separately owned, and other entities and/or marketing names, products, or services referenced here are independent of Osaic Wealth.
