Technology is allowing an investment strategy that was previously available mostly to high-net-worth clients to now be mass marketed: A customized portfolio can be offered to every client. Compared to a passive portfolio invested in pooled investments products, “direct indexing” seeks to mimic an index by owning all, or a representative portion, of the stocks in the index, individually. The next step to “custom indexing” allows the broker and the client to pick and choose those stocks from the index to invest in and hold.[1] The new products introduce the concept of tax-loss selling and its benefits to a wider audience. Not too long ago, Wall Street had suggested tax law changes to Congress which would have curtailed tax loss selling generally. Hopefully, the new push to mass market custom indexing will prevent that from recurring.
One of the criticisms of the new trend is that retirement plans don’t benefit from tax-loss selling because they are tax free or tax agnostic until withdrawal. However, most retirement plans convert capital gains not taxed while accounts are growing into withdrawals 100% taxed as ordinary income. Clients and planners may decide that something less than 100% of savings going into retirement plans is actually a sound financial decision if their taxable accounts can use tax-loss selling. A taxable account invested for growth minimizes current taxable income at ordinary rates and pays capital gains tax rates all the way up to and through retirement, a benefit that planners and their clients may appreciate.
Although it has taken awhile to develop, a custom indexed portfolio is a Woodstock account. Drop the number of stocks from several hundred to 35–45, use tax-loss selling to offset much of the fee, add some very sharp-minded portfolio managers to position the portfolio, and you are on the cutting edge—and actually, you have been. The customization of direct indexing is expected to “be the key driver across wealth and asset management over the next decade, even more so than alternative investments and digital securities.”[2]
A Shrinking Public Market Pool
Where do we see concerns? The size of the public market is shrinking. According to one source, “there are only 2,600 public companies with annual revenues greater than $100 million. That’s a small slice of corporate America, where there are 17,000 private businesses of that size.”[3] According to another source, “4,000 companies issue public stock that trade actively.” Five hundred companies make up 80% of that market value. Another 10,000 companies trade over the counter.[4] Government may overregulate the markets, the markets themselves generate intense pressure on managements of public companies, and competition within industries is fierce. Investors interested in participating in the American dream should be advocating for government to support our public markets, rather than handicap them.
The private markets present some issues for investors wanting to participate in them. According to one source, “wealthy individuals are a new, and mostly untapped source of capital” for the private equity industry.[5] Previously, the industry has mostly been selling to US public pension plans,[6] but this source of funding may be facing “overexposure” to this asset class, hence the need to find other sources of funds. A critic of the private equity industry suggests some solutions or guardrails for the industry. Because the debt piled on purchased companies in a private equity investment vehicle sometimes carries provisions for payments out of earnings, he suggests a more aggressive classification of that debt as preferred stock by the IRS, thereby decreasing the interest expense deduction. Reducing tax deductibility would effectively limit the use of debt, overuse of which can be harmful to portfolio companies.
Too Much Money Chasing Private Equity
The critic also suggests improving performance reporting: “year-to-year returns are heavily reliant on managers’ estimation of the value of portfolio companies, most of which are unsold even after holding periods exceeding five years.”[7] This brings us to the shorthand version of performance reporting that he likes, TVPI or total value to paid in. He describes a goal of 2.0, to which we’d add a time limit of “over a reasonable time period” and expand to “two or three times your money.” Some of our readers will recognize this standard, as we’ve used it in the past in QMP articles. The problem with mass marketed private equity is that there are just not enough good deals to go around. There is too much money being raised and an historic industry TVPI of less than 1.5 over an extended time period illustrates that fact.[8]
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