Dear clients and friends,
We hope each of you is enjoying the summer months and a more stable market environment. As we progress further into the second half of the year we wanted to provide a quick update on the markets as well as introduce a concept called “Direct Indexing” which is becoming a bigger topic of conversation (especially for high-income tax-sensitive investors).
Here are the stock and bond market results from the start of the year to the end of July 2023:
S&P 500: 19%
RUSSELL 2000: 13%
INTERNATIONAL DEVELOPED: 11%
EMERGING MARKETS: 9%
LONG U.S. TREASURY BONDS: -1.5%
AGGREGATE BOND INDEX: 4.5%
SHORT-TERM BONDS: 5.5%
Last week the Federal Reserve, the European Central Bank, and the Central Bank of England all raised rates by 0.25%. This had been priced into the markets for weeks and was not a big surprise to anybody. What was interesting was how the tone of the Fed was more dovish than in past meetings which indicates they are less likely to raise again unless there is an unexpected spike in inflation.
While there is no shortage of opinions on how the economy and markets will respond, we believe it bodes well for both the bond and stock market and we have allocated our portfolios to take advantage of this potential start to a new bull market in both. We continue to like areas of value in the stock market that are paying high dividends, as well as technology, health care, and energy, among others.
We expect 5-8% from the bond portion of our portfolios going forward and when rates eventually go down, bond prices should appreciate as well setting up potential total return figures we have not seen since the early 2000s. While we will assuredly have more bouts of volatility and corrections before year-end, it’s an exciting time to be an investor.
I now want to introduce a concept that most folks (even in the investment profession) are not familiar with, but before I define Direct Indexing, I want to briefly describe the evolution of different investment wrappers that many of you are already familiar with. Having a refresher on this will make the concept of Direct Indexing make more sense. Prior to the 1960s, most investors relied on stock brokers to recommend individual companies to invest in.
This allowed individuals access to the market that has created more wealth than any other, but it was rife with risk as some companies did well, but others failed. If you own shares of a company that goes bankrupt, you will likely lose your entire investment. Mutual funds had been around since the 1920s but did not really become prominent until after Harry Markowitz developed Modern Portfolio Theory in 1952. Mutual funds allowed investors to still access the stock market, but to do so by purchasing shares of a fund that was professionally managed and allowed diversification across many stocks. By holding shares of the funds over long periods of time and not panic selling during bouts of downside pressure, it became very difficult to lose money in the market.
Mutual funds continued to grow in popularity as they became the primary vehicle used in 401k plans and an easy way to track popular indices of stocks published by Standard & Poors and others. The main downside to mutual funds was, and still is, the tax inefficiency.
Mutual funds are pass-through vehicles. So if a fund manager bought shares of Starbucks back in 2008 for $10/share and decided to sell those shares in 2023 for $100, that gain is passed on to the shareholders of record in 2023. If you bought shares of the fund one day before the distribution of capital gains in 2023, you still owe the tax liability even though you didn’t get the growth benefit of Starbucks from 2008 – 2023.
One solution to this problem was the advent of Exchange Traded Funds (ETFs) in the early 1990s. ETFs are similar to mutual funds in how they own a large number of stocks or the ability to track an index, but they in almost all instances are not required to pass on capital gains to shareholders. This is possible through an in-kind exchange mechanism where appreciated shares of stock are exchanged with a market maker, so technically nothing has been sold that would trigger capital gains tax. We use many ETFs in our portfolios for their tax efficiency and lower cost structure. Each year mutual funds are losing assets in favor of ETFs and it’s unlikely this trend will stop.
I explain all of this to introduce what is likely the next iteration in this modernization of tax-efficient portfolios, Direct Indexing. Direct Indexing can be defined as owning outright the individual stocks that comprise an index rather than shares of a fund. Right now the S&P 500 is comprised of the 503 largest companies in the U.S. Instead of having a fund manager buy all 503 companies, and rebalance them based on how big each company is relative to the other, an investor using Direct Indexing would actually own a subset of these companies.
You are probably wondering why this is advantageous to an ETF, and in many cases it wouldn’t be, but the main reason is it allows for harvesting tax losses throughout the year while still maintaining close performance of the index.
You can see from the image above that there are opportunities to harvest tax losses even in years when the market is up, down, and sideways. By harvesting tax losses, you have the ability to offset capital gains incurred elsewhere during the year and also to carry them forward for use in future years if losses exceed gains in the current year.
One important thing to note is Direct Indexing only makes sense in non-retirement accounts since those are not subject to capital gains tax. And it really only makes sense if you are generally speaking in a high-tax bracket and are not seeking to outperform an index.
At Bauer Heitzmann we have many great Direct Indexing options that could make sense for a variety of scenarios and hope you found this information useful. There is much more to this discussion than I’ve outlined in this writing and our team welcomes any conversations around this and any other topic of interest.
As we partner alongside each of you in your financial journey we will keep Direct Indexing as an arrow in our quiver if it makes sense for your situation.
As always we appreciate the trust you place in us and wish you all the very best.
Stephen, Dan, and Chris