Don’t poison your clients’ portfolios with Direct Indexing!

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Direct indexing sucks – don’t do it. Here are the reasons it will ruin your clients’ portfolios and you should run away as fast as you can.

For those of you who are new to my blog/podcast, my name is Sara. I am a CFA® charterholder and financial advisor marketing consultant. I have a weekly newsletter in which I talk about financial advisor lead generation topics which is best described as “fun and irreverent.” So please subscribe!

Sara Grillo, CFA is a highly fun and slightly crazy marketing consultant based in NYC.
I am an irreverent and fun marketing consultant for financial advisors.

Scott Salaske of Firstmetric and I have one major thing in common – we both hate Direct Indexing.

Seeeeew, because of the Wall Street multimillion dollar marketing budgets, you’ve probably seen all the advertising for the following:

  • Blackrock direct indexing
  • Vanguard direct indexing
  • Schwab directing indexing
  • Fidelity direct indexing
  • Morningstar direct indexing

I mean, really, everyone is jumping on the “make a dollar off the unsuspecting consumer” bandwagon, so all these products are hard to miss. If you are sitting there wondering, “Should I use direct indexing for my clients”, consider these points about the drawbacks of direct indexing.

The negatives of direct indexing

Should you use direct indexing?

No!

The following flaws of direct indexing make it a bad choice for most people. But by the way, nothing in this blog or podcast can be interpreted as investment advice specific to any individual. These comments are intended as general guidance; for specific recommendations for your personal situation, consult a financial advisor.

#1 Direct indexing is not really indexing

Wall Street has engineered this term “direct indexing” to capture the attention of fee only advisors who are obsessed with John Bogle. Direct indexing, once personalized and/or sampled, will result in a portfolio that resembles an index no more than a plate of scrambled eggs does.

What does the term “direct indexing” mean, actually?

Direct indexing is simply taking the constituents of any one particular index fund, breaking it up into its constituents, and holding them in a separately managed account as individual holdings instead of altogether in one line item ETF or mutual fund.

Boom!

You would think that it would be enough for these Wall Street machines to earn their 15 basis points (or whatever spread they are charging, I’ve seen some go as high as 60+ basis points). But they take it a step further with the allure of “personalization”, offering to customize it to the specific desires of the client (example, they don’t want to own tobacco stocks). This drives up the tracking error, or the deviation of the portfolio from the index it was intended to replicate.

So in a nutshell that’s what the term “direct indexing” means. It’s a misnomer but for the purposes of editorial simplicity we’ll use that term for this article. I prefer the term “overly diversified SMA account” ; it’s more suitable to describe these structures.

#2 Tax harvesting benefits are exaggerated

All the direct indexing providers advertise the benefits of tax loss harvesting. But they are not providing you with the other half of the story:

  • In most cases you don’t really need to tax harvest on a consistent basis. You can do very well for clients by harvest tax losses occasionally when the market dips.
  • The role of the wash sale rule and the 60 day dividend rule are downplayed whereas both of them can interfere with the tax benefits that tax harvesting through direct indexing is supposed to create.
  • Tax loss harvesting can also be very hard to control. You may wind up with way more tax losses than you need, and you can only apply a small amount of the loss to each year’s taxes – the rest you have to carry forward.

#3 Direct indexing’s real goal is to get the client stuck for the benefit of Wall Street and the AUM peacocks

Just like whole life insurance, annuities, private equity, hedge funds, and interval funds (did I miss anything?), direct indexing is designed to lock up the clients’ portfolio into the hands of the financial advisors who put it there.

Let me ask everyone reading this blog.

Have you personally ever owned 500 stocks?

Or even 100 stocks?

Nobody is going to want to unwind a portfolio of 500 stocks.

Now you get it – the real objective is to put the portfolio in a place where the options are limited, which means for job security for the financial advisor AUM peacocks.

There are alot of arrogant financial advisor AUM peacocks strutting around - avoid working for them!

#4 The fees are obfuscated and embedded in confusing ways

How much does direct indexing cost? Is it expensive?

Great question!!!

Does anybody reeaaally know?

Most financial products are a Christmas Tree of fees; direct indexing is no different. There’s no answer the question of whether direct indexing is expensive or not, because it’s embedded in a way that is so obfuscated in certain instances that nobody can tell how much it really costs anyways.

Just add another layer, right?

If you look at any direct indexing provider’s “fee schedule” (if it may be called that) the language is usually ambiguous and confusing, lacking transparency into all applicable charges that the portfolio will incur. This happens frequently but not in all cases.

If you are going to invest your clients’ money into anything, all the charges matter. Even if they don’t seem material to you – they matter. Get a list and map out what happens at every point from start to finish in terms of fees charged to the portfolio, and verify every aspect. Don’t just trust what the provider says.

Potential lack of transparency into how expensive it is may be regarded as another negative of direct indexing.

#5 Direct indexing is a better deal for the financial advisor and Wall Street than the client

As you can see, direct indexing really sucks for the clients but is probably one of the best deals to happen in a while for Wall Street and the financial advisors who allow their clients’ portfolios to be lit on fire. I hope you won’t do this. If you need more convincing, listen to the podcast.

It’s just another example of not putting the clients’ interest first, chasing shiny objects.

Add it to the long list.

When is this going to end? Where are all you “fiduciaries” out there who are supposed to be valiantly defending the needs of the client?

Huh?

Despite all the negatives of direct indexing, why has it become so popular?

Sadly, the large cohort of fee-only financial advisors who emphasize low cost index fund investing and financial planning at the de-emphasis of investment management often are compelled to (wrongly!) feel their simple, clear business models are inferior to their competition, the private banks like Goldman Sachs who have shiny objects left and right to impress their wealthy clients.

Add to that the slick marketing pitches and the media hype, and you’ve got financial advisors willing to consider direct indexing’s use case – when they really shouldn’t. That is why direct indexing has become so popular. Entirely irrational.

Oh, I forgot – here’s another reason why direct indexing has become so popular. We believe that direct indexing has been pitted against ETFs because all the costs have been rung out of ETF indexes, and there needs to be a new way for Wall Street to squeeze fees out of index investors’ portfolios.

Don’t be fooled – there are clear negatives to direct indexing that should not be ignored. It doesn’t matter how popular it may be with other people – it makes no sense and shouldn’t be used. If you don’t believe me yet and want more reasons direct indexing is bad for clients, I wrote a pretty long blog about why you should run away from direct indexing in Advisor Perspectives magazine. Enjoy!

Direct indexing vs. ETF

We think ETFs should be the logical choice if a financial advisor has the choice of picking direct indexing vs. ETFs for their clients, but unfortunately logic doesn’t always prevail.

This isn’t a recommendation for any particular financial advisor- do your own research – as each option has its own benefits and drawbacks for your and your clients’ personal situation.

In general, we believe ETFs are better for clients than direct indexing.

We think this because ETFs:

  • Don’t add as significant an additional layer of cost.
  • Don’t lock the clients up into a gazillion individual positions, because an ETF is just one simple, clear line item holding.
  • Don’t require as much time, skill, and effort to actively manage the underlying holdings which is something most financial advisors are not prepared to do anyways.

In short, if we were given the choice of direct indexing vs. ETF, we’d pick ETF but there’s no guarantees this would work for you. As we said, do your own research as nothing in this blog may be interpreted as advice specific to any one individual or client’s specific situation.

Sara’s Upshot on direct indexing

What’d ya think of my blog on direct indexing? Was this helpful?

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Podcast transcription

0:00:00.5 SARA GRILLO: I don’t care how many PhDs are gonna argue with me to the death, direct indexing stinks. Okay, what’s a financial advisors today? I have Scott Salaske here, CEO of Firstmetric. Hey Scott. How you doing? Good, thanks for being here. And we’re gonna be talking about why direct indexing stinks. This is a perspective that the media and the vendors are not putting out there, and I think it’s very valuable, ’cause spot is probably one of the only people talking about it, and one thing I just like in general about his cots, LinkedIn and Twitter, is that you can learn so much about the other side in a way, Scottie, much a consumer advocate because he’s always exposing what a lot of the commercial perspectives don’t about financial advisor practices and products, etcetera. So he’s a great person to follow. Okay, Scott. So first of all, let’s start. What exactly is direct indexing?

0:01:00.9 SCOTT SALASKE: Well, direct indexing, we’ll talk about in its simplest form, it’s really a concept that’s been around for quite a while, a long, long time with a new name on it, a long time ago, and still to today, there’s what’s called separately managed accounts that had been very popular in the financial services community, and what these are, these accounts are managed to a certain specific style or strategy, where the managers of those strategies go out and pick individual stocks to try to basically beat a specific certain market or benchmark that’s out there that they’re trying to… Target, they’re not trying to get the returns of the market, they’re trying to beat the return, so what direct indexing now has come into play is the idea that we’ll tack on the name of indexing because it’s become pretty popular in the last… Let’s call it 10 years, give or take, and they’re kind of writing on the coattails of the index phenomenon that’s been going on in the markets. So when you throw that name on there, people now are getting a little bit confused as to, Is this actually indexing? If I were to go out and buy an index fund, or is this actually something different? So in its simplest form, it’s really a strategy where an advisor or a separate account manager is going out or both, you could have two different strategies and still call it direct indexing, they’re going out and they’re buying individual stocks and they’re calling it indexing because the initial try to target to an index, let’s say the S and P 500 that many viewers might be familiar with, so they’ll go out and they’ll buy close to maybe 5 00 stocks, depending on how they structure that, there is a concept called sampling where they might be able to reduce the number of holdings to sort of mimic the returns of the S and P without buying all 500 individual stocks, but you know…

0:02:59.3 SARA GRILLO: Did they do that? Why do they sample?

0:03:01.7 SCOTT SALASKE: Well, so you don’t own as many stocks, it’s a little bit easier to manage the portfolio, and if they can get the same return as the S and P by doing that, they’ll go out and do that. So the idea with that is they’re trying to match the returns on the market, but where today’s new phenomenon comes in with direct indexing is, is that they’re not just trying to do that, they’re letting an end client or an advisor, depending on who’s doing this customization to customize the index, so as you begin to look at it and say, Well, I don’t want certain stocks in there, whether it’s because of social, environmental or governance ESG concepts, socially responsible investing, some clients like to use… So they go out and pick out stocks they don’t want that don’t meet their socially responsible screens and systems that they put in place to screen the stocks, and then also they look at it and they basically… Don’t stop there, they go on and say, Okay, what else do you wanna do… Do you wanna customize this in other ways, you just don’t like a certain stock for a certain reason, so once you start doing all this, you’re not indexing anymore, so that it starts out as Direct indexing from a marketing standpoint, but then it kind of morphs into this full-blown active strategy of picking stocks and putting different criteria on it to develop really a strategy that’s very specific to that person, and it’s not an index, it’s just their specific investment strategies, so hopefully that was a little bit of a mouthful.

0:04:37.4 SCOTT SALASKE: I kept it a little bit simple, but… Go ahead, Sarah, ask away.

0:04:41.3 SARA GRILLO: Okay, now, you had mentioned sampling, in the case that the separately managed account does not directly replicate the Index, why is it then not indexing from a mathematical standpoint, what does that do to the expected returns of that direct index that is sampled or customized…

0:05:10.7 SCOTT SALASKE: Yeah, doing a sampling is not all that unique. A lot of index providers, let’s say for a vanguard, for instance, they run an S and P 500 Index Fund in different varieties and mutual fund, an ETF and so on, and sometimes they may do sampling or other people that run a specific index strategy. The difference here is, is that when you’re taking a sampling, is most of the time being done as a way to, again, minimize the number of holdings, so maybe it’s not over as overwhelming for a client, they open their statement and they have 500 individual stocks or a thousand individual stocks, Schwab came out with a direct indexing strategy that they’re index into the Schwab 1000 index, which is their own proprietary in-house index, so do you wanna own a thousand stocks or do you wanna own a sample of those straps that match that same strategy that they’re trying to target to that index and get the same results, but the issue of direct indexing is, is that people are customizing this beyond just taking a normal sampling that an index provider or an asset manager would use to replicate an index.

0:06:24.2 SCOTT SALASKE: They’re taking that sampling so automatically out of the gate, they’re not buying all 500 stocks if you were trying to buy the S and P, but then on top of it, they’re also now picking and choosing of those 200, 300, 400 or whatever number of stocks that they’ve sampled to now have a custom type of strategy for that specific client, so you get a lot of tracking there, and this could be positive or negative, but you’re not at that point getting the returns of the market through a traditional index fund type of strategy. So my biggest complaint is…

0:06:59.0 SARA GRILLO: That is what I was getting at, right? The tracking error.

0:07:02.3 SCOTT SALASKE: Yeah, so my biggest complaint with this is that everybody out there is calling this indexing, it is not just direct indexing, there’s all kinds of names, there’s direct indexing, there’s custom indexing, there’s personalized indexing, so it depends on what provider out there is in really pushing this right now, and everybody is pushing it right now, so that also puts a red flag up for me as an advisor, being in this business for over 20 years, that when all of Wall Street, all of the advisors and everybody’s talking about direct indexing… Everything you read in the industry publications, all direct in vaccine to me, that’s making money for Wall Street, that’s making money for advisors and complicating your life as an incline and also potentially charging you more for these and potential tax nightmares down the road. So that’s my biggest challenges here is calling it in vaccine when it’s not really indexing

0:07:58.5 SARA GRILLO: A spot, a few more things. Why, when directing vexing has been around for a decade, it’s now just becoming the range

0:08:10.3 SCOTT SALASKE: Wheel, the biggest reason that everybody will tell you now is because of the elimination of transaction cost and trading commissions to buy individual stocks, so that’s one area where you’re not paying portrayed to go out and buy X number of shares of IBM or Microsoft or Google or whatever stock they’re trying to buy in the portfolio, the other thing is, is the idea that technologies progressed and you can buy fractional shares, so it allows people that… Typically, these types of strategies were reserved for the ultra wealthy where they could go out and replicate an index and buy 500 shares, let’s say the S and P 500, they don’t mind paying some small amounts of trading commissions, they don’t need to buy fractional shares because they have enough money to go buy whole shares with other… They’re moving in an area now where they’re trying to open this to everybody of any account size, and the idea that before fractional shares, you didn’t have the ability to do that, they couldn’t go out and buy 500 stocks. If someone was investing 25000 or 50000 or even 100000, because you may not be able to buy the stocks the number you need it in proportion to the index weights, if you’re just buying whole share.

0:09:30.0 SCOTT SALASKE: So I think those two things, the idea that trading costs have gone down to nothing to buy stock for anybody these days, if you’re at a brokerage firm, and then also fractional shares allowed this to come about along with technology to drive the engine behind it to keep those indexes and sync and whatever, the custom strategy is.

0:09:52.0 SARA GRILLO: Okay, so we’re gonna talk about taxes in a bit, okay, the tax implications of this kind of a thing, but last pause here on a key concept that you’re talking about, which is what it’s gonna look like to the consumer, because that’s… My concern here is that if I have a… I see alter is coming out with this strategist portfolio, these… Whatever this is, strategist, suite of portfolios. Okay, so I have… Let’s say there’s a… Not speaking about otters product, you’re just in general, let’s say I have a US equity direct indexing product that I’m offering a… I’m a custodian, and by the way, custodians love this, they charge for it, but they actually should give it away for free because the order flow that they’re getting from it is just gonna make up way more than it anyway.

0:10:42.4 SCOTT SALASKE: Which that’s a different topic. And many people don’t know pay for order flow, so that’s a different to…

0:10:49.0 SARA GRILLO: The trends are not really free everybody, okay? If I have a US equity direct index portfolio that I can create for these clients, and I say the expected return for this portfolio, this index mimic and index with an expected or historical return respect to return or whatever they say, okay. Let’s say 20% annually. And the standard deviation is 12% annual. And then the client says, Okay, I like US equities. I don’t want this special makes me feel warm, fuzzy, personalized strategy. Oh, I’ll do it. Yes, please do you convert my portfolio to this, in their mind, they’re thinking, Okay, so I’m gonna get something that replicates an index that does 25% or the 12% risk, but now it opens up to the Wild, Wild West because mathematically you’re introducing somebody variable, so let’s say, I also say, But wait a minute, I don’t like news. I want you to get every stock out there out of the portfolio, or can you overweight companies with more women executives? ’cause this is my portfolio that’s personalized, he told me I was gonna be a personalized, so now it’s like I can end up with something that’s unrecognizable in terms of the risk return profile that was a rampant me, Am I driven or why? No.

0:12:25.1 SCOTT SALASKE: You’re absolutely right, and I think that that’s the biggest challenge. The idea that you can go out and you can buy individual stocks today and a client can or an investor can, and buy whatever stocks they want that are accustomed to them. The issue here is, is that it’s being wrapped up in a rapper called something for really at the end of the day, the basic idea to extract another fee from a client, so if you go out and you buy 200 stocks on your own and develop the Sarah custom strategy, you have your own strategy, and that may not look no different than a direct indexing portfolio after you pull all the stocks out you don’t want, and you exclude certain industries and you over-wait to certain things, you might still end up with 200 stocks or 300 stocks, but now you’re paying a fee to a place like Charles Schwab altruist, fidelity, whoever the provider is, it’s allowing the platform to exist in their ecosystem in addition to, of course, an advisory fee that you’re paying an advisor.

0:13:32.8 SARA GRILLO: Okay, so Hal, let’s talk about the fees though, what have you seen the fees be for this kind of a product?

0:13:41.6 SCOTT SALASKE: It’s kind of all across the board. Right now, everybody is kind of trying to compete with one another, so Schwab had indicated when they roll this out in June, their platform for direct indexing is gonna be somewhere around half a percent. Fidelity, I think is a little bit under that. All trust talks about in June and they roll it out, it is kind of a funky schedule, I don’t really understand how the fees work on that there’s kind of a set fee and then they’re gonna have a variable fee based on how much risk you have in your portfolio doesn’t make a tooth.

0:14:14.6 SARA GRILLO: Five average financial advisor doesn’t understand how the fees work, how are the client’s gonna understand, and this is exactly what… This is the Humpty Dumpty portfolio that Rick Terry was talking about, that’s just chuckle of these feed products that no one understands what the fees are, they’re not clear. It’s not clear. Right, and I like you. And I would say more than average, scrupulous financial advisor is sitting here saying, I’m confused, I’m seeing all these different fee scheme as it’s not clear what the meaning…

0:14:58.0 SCOTT SALASKE: Part of the challenge with that Sarto-me, it’s not clear. For two reasons, number one is, is that a lot of the places altruist as an example, ’cause they just rolled this out, and I’m not picking on them because they’re all the same everywhere, is that they rolled it out and you can understand some basic fees to it, but then they add these variable fees on and other things, and part of the challenge is, is that I think that it’s confusing because they’re not explaining it well to people, number two is that it could be confusing on purpose from an aspect of… If you have two separate fees, one is more of a lower fixed fee, and then this variable fee there talking about, if you’re looking at them separately, and I said, Well, that’s not too bad, but when you add them together, they’re just as much as everybody else out there, so everybody’s got their own unique way, they’re trying to package this stuff up and sell it, but it’s basically the same stuff, and everybody’s charging roughly the same fees for it because they’re competing with one another, even Vanguard, sadly has got into this business, they acquired an index a direct indexing.

0:16:04.3 SCOTT SALASKE: I hate him calling in the direct indexing, but we will for this conversation, a direct indexing technology platform where they could offer this to advisors and then also end investors that are direct with Vanguard at some point in the future. And again, this is an avenue, even though Vanguard is not a for-profit company, that’s a different conversation, but my views are they’ve been more and more towards profit in the last how many years than they’ve ever been, and this is just another avenue to… I think in many ways, I keep the index fees low for true indexing, but at the same time, be able to recoup some of that and these other things that they’re doing, whether they’re active funds or private equity offerings, and now this direct indexing offering that they can go out and charge the same higher fees that everybody else is charging for, so it’s a confusing, wild wild west out there, and I think it’s gonna be more confusing, and the problem is, is that the person that’s gonna get hurt the most is the end client or the end investor, and there’s a lot of reasons we can talk about why that is, but that’s the ultimate goal over long-term.

0:17:13.2 SCOTT SALASKE: Okay, Scott.

0:17:14.2 SARA GRILLO: So let me just go to The Altruist strategist.

0:17:21.0 SCOTT SALASKE: Which is a weird name, by the way.

0:17:22.8 SARA GRILLO: We are in a coma, you know that it’s gonna be creative pricing, when you see weirdest foundations this that

0:17:33.9 SCOTT SALASKE: I’m confused by that whole concept with all true. And that’s again, a different conversation, they started out to be a custodian, and now we’ve got all these offerings and model portfolios and no direct indexing and different topic.

0:17:44.3 SARA GRILLO: But altruistic intentions, but here we are with direct indexing, so Paradox. Okay, good, so I’m reading this from the altruists news section. For large cap stock exposure in the US, we use direct indexing to target the largest 500 companies in the US, because we are not using a fund, there is no expense ratio associated with this part of the portfolio. The direct indexing component makes up more than 80% of the total US equity allocation and helps to drive down the cost of the entire portfolio, in fact, with direct indexing, the blended expense ratio for the US stock allocation is less than one basis point for 100% equity portfolio, the overall expense ratio is two to three basis points annually…

0:18:41.9 SCOTT SALASKE: Yeah, sounds great, right.

0:18:46.8 SARA GRILLO: Okay, overall fees to the investors would include expense ratios from the funds altruist model marketplace fee for the strategist portfolio, which is one basis point per month, unless absorbed by the advisor and the advisor fees which are at the discretion of the advisor transaction and other brokerage fees may also apply, which can be found in our fee schedule hyperlink to the fee schedule within Astros important fee information. These strategist series with direct indexing, there’s a model marketplace fee of 12 basis points, 0-0-1% per month automatically deducted in arrears from investors accounts man, unless absorb by the advisor at their discretion, investors will also indirectly bear the fees and internal expenses of the underlying funds how then the model portfolios subscribe to their account model marketplace fees do not include other related costs and expenses such as transfer fees, administrative fees, and other fees in taxes on brokerage account or accounts or securities transactions assessed by the introducing broker deal or alters Financial LLC. Or third parties. And then it goes on for two or three. There’s three more paragraphs, and those are just risk disclosures, I mean, how clear is that to you, it sounds like…

0:20:27.3 SARA GRILLO: Okay.

0:20:28.7 SCOTT SALASKE: It’s not clear. I think that’s really the bottom line at the end of the day… Yeah, I think I can figure it out, but I’m in this industry and have been for 20 plus years, so what you read… I can’t tell you exactly what fees you be paying here, but I gotta sit down and digest it, read it, figure it out, but I think for the average investor that’s out there are even a client of an advisor, they’re gonna have no idea what they’re paying and then you read that one little line in there that unless the fees absorbed by the advisor, so again, there’s no transparency to what fees are being charged, her fees are not being charged, is all truest charging fees directly, is the advisor passing those fees under the client as part of their 1% AUM or whatever fee structure model that they have, so it is unclear, and I think even an offering from Schwab or Fidelity is much more clear in the aspect that, here’s our fee. This is what you’re gonna pay. It says nothing to do with the advisor fees, but it’s still, it’s a half a percent or it’s a little under 15% depending on what firm you’re looking at doing this direct indexing strategy with.

0:21:35.0 SCOTT SALASKE: So the fees can add up and you get back to, at the end of the day, they talk about a US equity-based strategy that would count for 80% of the US equity allocation in a portfolio. Okay, well, where is the other 20% of the US in an index fund? Are they using an ETF and if it’s good enough for the other 20%, why isn’t it good enough for the 80%, so that’s the real question here…

0:22:00.9 SARA GRILLO: Exactly, it’s just confusing. Why? But they never explain why, nobody

0:22:07.2 SCOTT SALASKE: Explains it as the same thing, Schwab is doing the same thing, they’re coming out there saying, Yeah, we have a direct indexing strategy to the Schwab as Schwab 1000 index, which is proprietary and a few other indexes that are out there, but it’s not to replicate and until your portfolio… And this is also part of the challenge that if direct indexing was so wonderful, why aren’t we doing it with the entire portfolio, why aren’t we going out and buying 10000 bonds to replicate the total bond market? Why are we going out there? It’s actually more than that. Why aren’t we going out there to buy small cap stocks to replicate a small cap index, and so on is a real estate index, they’re focusing on the low-hanging fruit where they know that they can really mimic the broad US equity large cap market and be pretty close to that and extract fees to do it, but the problem is, is that the end client again, or the end investor is gonna be saddled with the mess afterwards, and to me, that’s the bigger challenge that is not being really explained up front, and that involves owning hundreds, sometimes maybe thousands, depending on how many strategies that are going on, but certainly hundreds of individual stocks in their portfolio, and then the idea that we…

0:23:28.0 SCOTT SALASKE: Maybe is on your agenda. Tax loss harvest teams.

0:23:31.4 SARA GRILLO: Let’s say you have an advisor charging 1% on… Let’s say that there’s… They’re gonna do this with a million, a million dollars of someone’s money, the advisor is making 1% on that. Altruist is gonna tap on 12 basis points a year. I think it’s funny, by the way, also that they state the fee on a monthly basis… Right, and then in the footnotes, they stated in an annual basis.

0:24:00.0 SCOTT SALASKE: And I think that’s the fixed fee, but there’s a variable component too to that that I’ve read somewhere, I don’t know if it’s on their website, what are the press releases that came out…

0:24:08.5 SARA GRILLO: Well, there’s transaction in other brokerage fees that can be found in their fee schedule.

0:24:13.1 SCOTT SALASKE: But this was another fixed fee basis points, so you had the 12 basis points, eight monthly or… In addition to that, it… Or, but in addition to that, you had a variable fee that they explained… I don’t think it’s on the website. It was in a local press release that I just read recently in last day or suggestion to that they’re gonna have an asset-based fee depending on the risk that you’re taking, I don’t know what that means when… They’re just running a US equity strategy, so you’ve got a 100% in stocks for that portion, so I don’t understand where the risk comes in, but maybe it’s for a model.

0:24:48.2 SARA GRILLO: Well, I think that they’re just saying that whole idea of to customize… Right. Okay, well, let’s go back to the discussion to… ’cause they’re really… The rating

0:24:58.7 SCOTT SALASKE: On them, by the way, they’re just jumping on the same train as everybody else, I think they are doing some good things on the technology side, but this is the… Totally, again, jumping on the same train as the rest of the industry.

0:25:11.0 SARA GRILLO: What does this look like though, from the viewpoint of the consumer, ’cause we just covered it from a fee perspective, but… What does the product look like?

0:25:23.1 SCOTT SALASKE: Well, the product looks messy, I mean, at the of the day, I don’t know, it depends on the client or the end investor, if they’re doing this on their own or through an advisor, either way, you’re gonna come up with the same idea that… How often do they look at their accounts when they log into the custodian that’s holding it, whether Schwab, Fidelity, TD Ameritrade, wherever, and look at their holdings or their monthly account statements they get, or there are reports from their advisors, they’re gonna be 20, 30, 40, 50, 60, 00 pages long with all these individual holdings and hundreds of transactions potentially every month or two, because of again, this tax loss harvesting concept, so the transactions will be enormous over a year, the holdings will just be so cumbersome. You really don’t even know what you want unless you drill down and look at every single stock in the portfolio, either every day or every month when you get your statement, so it’s complexity, it’s just making a concept that you can go buy the S and P 500 at Vanguard or anywhere else, anywhere from three to five basis points, and have a cheap fund that you know you’re gonna get the returns of the S and P, or you can go out and you can have these 500 stocks they buy individually at the same weight as the S and P, but now you can customize it however you want, so you may do better, you may do what words, you’re not gonna get the returns of the S and P when you start customizing it and then on top of it for the privilege of doing that they throw this fee on top of it that you wouldn’t ordinarily have with an index fund other than this very low cost, literally pennies that you’d be paying the index manager to run the index strategy.

0:26:59.6 SCOTT SALASKE: So the complexity side is enormous, and then again, we’ll talk about tax-less selling, but I’ll talk about just the complexity from tax season, when you go to do your taxes now, your CPA is just gonna love you when they gotta enter hundreds of pages of buy-and sell transactions throughout the year for all kinds of stocks in your portfolio, so I don’t know, you know how that’s gonna play out in the accounting world, but I can only envision that if a CPA or some support, the staff they have working on your tax return is gonna have to spend extra time by doing data entry, they’re gonna potentially charge you more to do your taxes now as a result of this type of strategy like swab for instance, we use that as an example, if you have a count at Schwab and your managers use any direct indexing strategy or you are… You’re gonna own maybe initially out of the gate, anywhere from a couple hundred to 500 stocks to replicate it.

0:27:54.5 SARA GRILLO: It… You get the proxy reports and the sheath… T’s

0:27:59.4 SCOTT SALASKE: Absolutely true. And there’s been no real… Yeah, there’s been no real talk about that, maybe eventually they’ll come out with a solution where they have that more online and maybe it’s wrapped up and deliver it, but I mean you’re technically the owner, and that’s also the thing that’s pushed with direct indexing, is that you actually own the individual company share, so as an owner of the actual shares, you will be getting proxies for every single stock to vote on boards of directors or other things that are put up to a shareholder vote, annual reports. Some of this stuff you can set up to get in an electronic way, but you’re still gonna be inundated, whether it’s through regular mail or email with these notices all the time.

0:28:41.8 SARA GRILLO: But I would know what to do, I mean like, Oh wow, you get the shareholder notification we wanna merge with this other company, testable, I don’t know.

0:28:53.7 SCOTT SALASKE: The way that Aditi, you gotta look, an advisor doing this direct indexing strategy, the way that they’ll probably, I’m just saying probably get around us, is that they’ll assume the responsibility is the advisor to vote the proxies for you, so a lot of advisors and separate managed accounts would do that on behalf of the clients. So they’re not getting all of that material. But then again, part of the idea of the promotion of this, besides some of the stuff we talked about with tax-less selling that they’re promoting, some of the other stuff is that you… On the individual companies, so if you own the individual companies and they’re voting your proxies for you, then you’re not really owning the individual companies where you’re sharing your voice about these individual companies, so you can almost certainly gate that that’s really a benefit. They’re not really interested advisors or providers of these strategies of you owning the companies, they’re just promoting a new strategy and yeah, we’ll take some of the administrative burden off the plate by we’ll vote these things for you, but at a… The average advisor has no record-keeping systems in place to be voting proxies and account for them properly with regulators of how they voted for this stuff, or a lot of small advisory firms, solo advisors, they don’t vote proxies for clients for that very reason.

0:30:12.0 SCOTT SALASKE: It’s too much liability and responsibility for doing the…

0:30:15.7 SARA GRILLO: Yeah, but also, let’s say that I were a… An executive at Amgen, and Amgen is in the direct indexing strategy. And how does that… What if I own shares the staff?

0:30:34.9 SCOTT SALASKE: It’s problematic. And then again, this will be touted as a benefit, if you worked as an executive at Amgen and now you’re heavy direct indexing strategy, that you can exclude Amgen from the strategy because you might already have a lot of stock in there or you’re not allowed to trade in it, because of black out period services.

0:30:53.6 SARA GRILLO: Let’s say I have inside information about what happens at Amgen, let’s say the financial advisor doesn’t do a good job on covering that… Maybe they don’t know, maybe I changed jobs that I do say that it’s all kinds of potential liabilities.

0:31:09.1 SCOTT SALASKE: Well, and it’s not just the advisor, the advisor needs to know about that and that has to be communicated to the actual person that’s running that individual, but company like Schwab or Fidelity or altruist or whoever that’s actually managing the direct indexing strategy with their algorithms and technology, if that’s not communicated to them as well and kept up-to date by sides, even the advisor knowing there’s multiple parties that have to stay in the loop on that type of

0:31:34.5 SARA GRILLO: An… Okay, sorry, this is… I don’t think this is a good thing in a initiating, I just… I think it’s just worsening what people hate about Wall Street in the beginning.

0:31:46.8 SCOTT SALASKE: It’s putting another wrapper on something that has already been in existence that people have come to a Wall Street, which is these separately managed accounts, and it’s because again, they’re all active strategies, it’s complexity it’s individual stocks, it’s higher costs, it’s just a new wrapper on it.

0:32:05.8 SARA GRILLO: Okay, now let’s talk about the… What the tax implications are? Direct index…

0:32:14.0 SCOTT SALASKE: Well, the tax implications, it’s sold right now to the public by everybody, as you’re not gonna have many tax implications because of the way in which they’ll manage the portfolio to, again, track an index or customize it to the way you want, and then you’ve got the stable of stocks mirrored to some custom strategy for you as an individual investor, and once that’s set, then the idea is, is that we’ll do our stuff behind the scenes, the managers of these direct indexing products, and part of that is as they move stocks around to make sure that they’re tracking in this, who knows what, because you’ve customized the strategy, they’ll do what’s called tax less selling at the same time. So as a basic example here, if you have the S and P 500, that one’s 500 stocks give or take, you’re gonna… You basically try to replicate that, let’s say you don’t do any customization at all, you’re just gonna do direct replication of that index, so they go out and buy all 500 stocks at the correct ways… And now you own the S and P, but instead of in an index fund, you own it all 500 individual stocks, so not all those stocks are gonna be going up at the same time the markets are going up, there’s gonna be actually some that are going down, so the idea here is, is that they would take the ones that are negative, that you’ve got losses in, sell those and re-deploy those in similar securities to maintain the structure of the portfolio, and how you can use those losses to offset securities that are in a gain down the road when you have to sell them for one particular reason, whether that’s again, to adjust the portfolio to keep it on track, or if you need money out of your portfolio or any other reason that you might incur capital gains and doing that.

0:34:10.4 SCOTT SALASKE: So the problem here is that there’s probably gonna be no consistency to how tax law selling is employed by any of these firms that are running these strategies. Do they do this daily? Do they do it weekly? They do it any time something’s at a loss, they just automatically take a loss, there gonna be no consistency to that type of strategy of tax law selling as part of the overall direct indexing concept. And when you do that, part of the problem is, is that now you’re accumulating these losses and that’s great, but using back to your example, you put a million dollars in this strategy, let’s say that’s all the money you have, or 80% of your portfolio or something, and you’re a retiree or you’re just getting ready to retire, you don’t have more money coming in, so everything just one into that strategy at once, so yeah, initially this might work out fine for a couple of years where they’re able maybe even longer, depending on the volatility and what the markets are doing. But you’re gonna get to a point where hopefully, nothing is in your portfolio to loss anymore because you’re not making new savings contributions in here where you’re sort of dollar cost averaging in at different points in the market where some things could continue to be at loss is depending on when you invest it, but you take that lump sum and you put it in, at the end of the day, if the markets do well over a two, three, four-year period time, your out-of loss is for the most part.

0:35:33.7 SCOTT SALASKE: And now you’re stuck with hundreds of stocks, low cost basis in these stocks now, and now you gotta live on this portfolio, so it just becomes a tax nightmare down the road… Well, this tax loss selling, it becomes even more complicated if this is a portion of your money, and then you have multiple advisors or you’re managing some on your own and you’re buying the same individual stocks that they’re doing tax less selling in these accounts because there’s this concept of what tax wash, that the IRS doesn’t allow you to take the loss if you’re basically buying the same security and other related accounts at the same time, so this becomes very complicated to try and coordinate this mess as well, and frankly, some of the robo-advisors out there that are not doing direct indexing yet, they’re on the radar screen, they’re doing still tax law selling with regular index funds and etfs… ETF is an index fund, so they’re using etfs as an index strategy, but they’re doing tax less selling. I’ve heard from several people, including a couple of people that became clients, that they don’t do it well, they just do it on an automated basis, they’re not really coordinating with what is going on in your other accounts or in other advisors you might have, or whatever you’re doing on your own, it just becomes a nightmare for your accountant or CPA to unwind at the end of the year, and you may or may not be able to even use these losses.

0:37:01.6 SARA GRILLO: How do we get here? Really, I think how… I just don’t know, there is such an emphasis on shiny objects, and although I am encouraged when I see advice, the advice only movement, or I see advisors that are simplify, that are staying away from complicated, structured, layered embedded situations. I am concerned because I’m seeing the next generation of advisors repeating the same mistakes that the old guard has made, and is because I think that there’s not enough people doing what you’re doing, and you and I may be right about how these situations play… How this plays out, we may be wrong, roleplay out in reality, but there’s not enough people questioning, and for that, the same direction that I have to fill the vendors though. I think it has to come… Some of it has to come to that then what does sales look like at the vendor company is that the people selling this, is there enough emphasis on ethics and marketing and where these products are coming from, because to some extent it’s the advisor’s falter not asking… Well, wait a second, even though I could make money acts or potentially offer the client benefits, do I really understand every aspect of what’s going on here, have I really thought through all the possible scenarios that I ask the questions, because I think that they’re not asking those questions, because when I see the market materials that are presenting things the way that they are, the marketing materials wouldn’t be that way if advisors were pushing back and saying, Well, you didn’t clarify that, because they would stop trying to represent things in a vague or confusing way, and they would address the question, the marketing materials will be clearer if advisors were demanding that they were clear or by asking questions, but they don’t…

0:39:19.1 SARA GRILLO: Yeah.

0:39:19.6 SCOTT SALASKE: That’s true. I think the materials that I’ve seen from Schwab, from Vanguard, what you just read from all true is so far, the limited stuff, some of these offerings are not even out yet, so obviously they can tweak some of this, but I think some of this is pretty much said in stone, this is kind of the way they plan on marketing this stuff, and I think part of the challenge is, is that even the concept of tax-less selling, I don’t like how that’s marketed because you read four or five different companies that are offering direct indexing strategies, these are not advisors, these are Schwab, Fidelity, altruist, some of the other Vanguard, you name it, that are jumping into this business of offering this product, you read the stuff they’ve written up and everybody’s different, you could earn an extra one to 2% a year, and from tax loss selling, you can earn an extra half a percent to 1%, you can earn extra 4%, I mean, if it’s that quantifiable and you could put an exact number on it, why isn’t all this marketing stuff consistent across the board, if everybody’s doing the same thing, they’re they’re replicating, again, whether it’s the S and P or some other index, if you’re getting a benefit from tax loss selling, why isn’t it the same on this platform, in that platform and this platform, it’s all different because nobody knows it’s just…

0:40:40.4 SCOTT SALASKE: Somebody did a study on something, and then these are the results of it, and as we know, products are… They’re not gonna put out negative stuff about products, it’s all the positive stuff, but at the end of the day, these returns also from tax law selling, I think it’s being sold to people, from what I’ve seen and talked to a few people that have encountered… This is that it’s being sold if you’re getting an indexing strategy, but it’s got extra juice in it because you’ve got this tax loss harvesting ability where you could sort of add another one to whatever percent of extra return to your portfolio that’s not really return… It’s just tax savings, but what’s not explained to them is the whole picture of how does that actually work? So yeah, if I book a bunch of losses and I use those to offset things at a game… Sure, I’m not paying any text now, but I might be paying taxes in the future, that’s not really being explained to people that as they sell things today and they’re buying new things at lower prices, they’re gonna have a bunch of securities in their portfolio, hundreds that are at low cost basis, because they’ve already captured those losses and now…

0:41:56.4 SCOTT SALASKE: Yeah, sure, you can use an off-set things that are at a game, but they run out when the losses are gone, not even what you’ve looked already and you carry those forward until gone, but just the portfolio itself won’t have any more securities that are at a loss, especially if you do lump-sum investing, like we already talked about, so I just think that there’s a lot of… There’s a lot of marketing in this that is just a lot of smoke and mirrors, if they’re selling indexing on one hand, but yet then they’re throwing them in something completely different, it still has the indexing label on it because it’s direct indexing. Personalized indexing. Custom indexing. So that’s the challenge that I think people have to figure out, is it… Everything is just muddy. It’s like, Oh, index funds, I know what index funds are… Oh, this is index investing. Sure, yeah, I’m open to doing that. When it’s not index investing, it’s just active investing, they’re just starting with an index and picking and choosing, and even if you don’t pick and choose, at the end of the day, as they do tax less selling, you still will not have the same portfolio.

0:43:06.8 SCOTT SALASKE: In fact, I had a client that we got out of this, but I kinda got stuck in it for a little while, and it was direct indexing… Before direct indexing was all the rage, in the last couple of years, they came to me as a client, and they had about 500 individual stocks and what a portion of their portfolio just for us, large cap exposure, and it’s a long complicated story of how they got there, but we had to go out and hire a low-cost vendor that has sort of been in this business for a while that actually does, or at the time now they’ve ventured to doing what everybody else is as well, they just did an index strategy where you would mimic the SNP, and then again, try to keep minimal tracking air and again, we’ll get out of these stocks over time or whatever your strategy was… Of course, in my case, I’m a big believer in plain vanilla passive index funds, buy the index fund, not all these individual stocks, so the idea is… We wanted to transition out of that. Well, he got to the point, very shortly after coming on board where he had very little losses in there, he wasn’t putting new money in, so everything was at a game, it was impossible for him to get out of that and do any future tax loss selling.

0:44:17.0 SCOTT SALASKE: So that’s kind of a real world example that I didn’t put a client in that, but they kinda came to me with that baggage of legacy securities and strategy that I had unwind and I said For out there somewhere, I can’t remember where… If it was social media or I was quoted in an article or something that said, I can’t wait to start on winding all of this crap for people as they realize what they’ve got themselves into, I wish they never got into it, but I think that they’re going to get into it, if they got an advisor that is not paying attention to what the details are or they just, again, our marketing this to try to keep a captive client at their firm because it’s too complex for you to manage on your own, you own 500 stocks, you’re never gonna be capable of doing this, let our computers and our people do this, and kinda locks in that client advisor relationship, but it’s great if you need an advisor, but again, an advisor making something more complex that doesn’t have to be… For the sake of trying to keep a client to continue to charge fees to that client, let’s do stuff that’s morally correct, let’s do planning and other things that you can earn fees, you don’t need to complex their portfolio to justify your value of doing something, or

0:45:33.8 SARA GRILLO: Why do you like this? Why are you questioning me a step, because I don’t see many other financial advisors that are…

0:45:43.0 SCOTT SALASKE: Well, I think that the biggest thing is, again, I don’t know, everybody’s motivations, but my motivation is, is I’m not in this business to do bring on as many clients as I can bring in… Regardless, give them everything that they want, and it doesn’t matter what it is. I’ve been in it long enough where I know what works and what doesn’t work. And at the end of the day, you don’t need complexity in your portfolio, that’s just gonna drive up fees, costs, overall taxes, again, you’re not gonna understand what you own, so if you keep everything simple and spend the time on other aspects that clients can control for instance, they can control how much they save, they can control how much they spend, they can control their taxes to some degree, if they don’t have their advisor doing this custom in vaccine or whatever, now focusing on Where can I help them understand what they own their strategy, but also how to get them to where they wanna go. And a lot of people don’t know where they wanna go. So an advisor’s time is much more spent on some of the stuff outside the portfolio, I tell people that after we go through the initial phase of getting back to your question of why am I like Why I am is because I just have seen too many people pay too much money.

0:47:01.2 SCOTT SALASKE: I mean, even an example of a client I actually have… They’ve been at Vanguard their entire life, they just dollar cost average into the market, they’ve accumulated substantial assets in the millions and millions of dollars, and they were looking to hire an advisor, they never hired an advisor before, and when they go out and they interview advisors, she the couple, they look at this and they say, Well, we already know what indexing is, we’ve been doing it all along, we want somebody to just pick up that strategy that we’ve already been using, so you go on your interview, like-minded people, you think… And he showed me a couple of the proposals he got back before ultimately we started working together, and one of them we looked at, it was they wanted to sell all his Vanguard holdings, and he has substantial holdings in a taxable account, they would add a tax bill probably of over a million dollars or more, and by all dimensional funds, because that’s the models that that advisor ran for the privilege of also charging this client about 60000 a year and financial advisory fees that the firm has. So it’s just one of these things where you gotta charge people far, fees provide fair services, and then you’re not gonna be for everybody.

0:48:16.1 SCOTT SALASKE: And that’s the way I look at it. I have a small practice right now, yeah, there’s a lot of assets. But I work with about 45 clients, and I like people that I’m working with, it’s a like mind of philosophy, they value what I do, I value what they do, and I don’t need to charge them a fortune to do it…

0:48:34.2 SARA GRILLO: You’re a flat fee advisor. Correct.

0:48:36.7 SCOTT SALASKE: Okay, so more than you wanted probably, but I just got on my soapbox a little bit.

0:48:44.2 SARA GRILLO: Well, I think that the moral of the story here is that in order to make progress as an industry where we can garner more trust and respect from the public, advisors are going to have to start asking questions of vendors, especially when it is related to products that they are considering for their clients…

0:49:03.5 SCOTT SALASKE: Yeah, I think that that’s true here, I think at the end of the day, some advisors probably know the answers to those questions and they just sort of choose to ignore it because this is kind of the current theme and they wanna gain market this type of strategy and other advisors, they probably don’t ask enough questions and they need to understand these products and they just rely on other vendors or platforms to do this stuff for them, and that’s when they get in trouble because they don’t know what they’re putting their client into, or if they do in the beginning, they don’t know the whole life cycle of at least today, what we know of how that’s gonna play out for a client, and then to me, the bigger problem is under either of those camps, how much did they explain to the client of how this actually works, it’s not… Again, indexing, it’s a custom strategy of only in individual stocks, it almost has to be explained to a client like I’m offering this, it’s called direct indexing, but it’s no different than me as the advisor going out and picking 100 or 200 or 300 individual stocks for you, What do I know about these companies? Again, same thing with the platform providers, they don’t know anything about these companies, they’re just making guesses, but they’re getting away with that because they’re not saying We’re going out trying to beat something like an index, we’re going out and we’re just trying to replicate the index for you direct indexing, but we’ll let you do all this customization to it, that you don’t end up with an index later, so that’s a part of the US…

0:50:31.6 SCOTT SALASKE: I don’t know that a lot of people, especially investors and clients understand it, once you start moving the pieces around, you don’t have an index anymore, you have the Sarah or this custom strategy that’s custom to us that nobody else is going to get. Now, don’t get me wrong, when you own hundreds of individual stocks, again, unless you’re overweight tremendously in one or the other, and you have kind of a call somewhat equal weight to me, you’re probably gonna get close to the index returns of whatever that strategy is, whether it’s large cap, small cap or anything else, but the problem is, is you still have hundreds of stocks, you still have tax nightmares, you still have another set of platform fees and type of it you could avoid just by buying index funds.

0:51:18.4 SARA GRILLO: Okay, well, we could go sitting here talking all day about this house… Thank you so much Okay financial advisor so you’ve heard us what we’re saying here please take this to heart and start asking questions I want you to sit down and start sketching things out getting better answers and more clarity and always consider Am I complexity things more Am I complicating things more by engaging in this way okay everybody so thank you Scott and everybody please subscribe rate and review this show

Sources

Altruist. https://news.altruist.com/introducing-altruists-strategist-suite-of-portfolios

About Scott Salaske

Scott Salaske is the founder and CEO of Firstmetric, a flat fee financial advisor firm in Troy, Michigan. Ever since the beginning of his 20+ year long career, Scott has pursued his mission of delivering high quality financial advice in a low cost and unbiased way.

Early on in his entrepreneurial journey, Scott saw firsthand the inherent flaws and conflicts of interest in the traditional sales and product driven approach, as several family members had lost a significant portion of their hard-earned life savings to high-cost, commission-based investment products and inappropriate advice.

It was at that point Scott thought there had to be a better way for investors to obtain unbiased advice and low-cost access to the financial markets. That lead him to start Quest Asset Management, with the novel idea of putting investor interests first as a fiduciary, which was practically unheard of at the time. The idea centered on the concepts of simplicity, keeping total investment costs and taxes extremely low and developing a custom investment plan for each client using low-cost asset class and index funds.

A few years later Scott merged Quest with another local investment advisory firm, Portfolio Solutions, that shared the same investment principles at that time. Several years after the combined merger, Scott went on to grow the combined firm from advising approximately $60 million in client investment assets under management to more than $1.4 billion. In early 2015, Scott sold his ownership interest in the firm. He started Firstmetric a few years later.

At Firstmetric, Scott continues his mission of delivering low cost, unbiased advice to clients. Along his journey he has been quoted in the following publications: The Wall Street Journal, Investor’s Business Daily, Kiplinger’s Retirement Report, TheStreet.com, Cheddar.TV, Crain’s Detroit Business and MarketWatch.com; among others.

Disclosures

Grillo Investment Management, LLC does not guarantee any specific level of performance, the success of any strategy that Grillo Investment Management, LLC may use, or the success of any program. Nothing in these materials may be construed as an investment, insurance, or financial recommendation.

Grillo Investment Management, LLC will strive to maintain current information however it may become out of date. Grillo Investment Management, LLC is under no obligation to advise users of subsequent changes to statements or information contained herein. This information is general in nature; for specific advice applicable to your current situation please contact a consultant or advisor.

Podcast transcription may differ from original recording and Grillo Investment Management, LLC may not be held liable for such errors.

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