Investing: Custom-Made Indexes for Cost-Conscious Index Investors

Traders work on the floor of the New York Stock Exchange during afternoon trading, in New York City, on Sept. 13, 2022. Michael M. Santiago/Getty Images

By Robert Frick From Kiplinger’s Personal Finance

A growing number of investment firms now offer Main Street investors a strategy called “personalized” or “direct” indexing that typically requires buying and trading stocks directly, mimicking an index.

Investment firms and advisers have long offered this strategy to the wealthy for an annual fee that often exceeds 1 percent of the portfolio’s value. But now, enabled by no-commission trading, smart supercomputer programs and the ability to buy fractions of shares, at least three firms: Fidelity, Schwab and Wealthfront, are repackaging the service for cost-conscious index investors. The new offerings enable you to dabble in personalized indexing with portfolios as small as $1, for fees ranging from $4.99 a month to 0.4 percent a year.

There are two main types of these new programs. One focuses on personalizing your portfolio by allowing you to invest in thematic baskets of individual stocks—green energy firms, for example—or to tailor a broader index by eliminating companies you may object to or that you have large positions in elsewhere. The other type, which typically allows less personalization, is all about tax efficiency, focused on harvesting investment losses to offset gains or income and reduce your bill.

Any new Wall Street offering should be scrutinized. And this one has plenty of critics: Rick Ferri, a financial adviser and president of the John C. Bogle Center for Financial Literacy, questions the fees and wonders whether the customized portfolios might make it harder to move assets from the provider that built the personalized index.

As for tax efficiency, investors will have to weigh any advantage against the increased complexity of their tax returns: Schwab warns its Personalized Indexing investors to expect 1099 tax forms that can exceed 50 pages, for example. And some individual investors might consider the minimum investment at Schwab and Wealthfront—$100,000—on the high side.

Even boosters concede that these new indexes aren’t for everyone. Daniel Needham, president of Morningstar’s Wealth Management Solutions, urges investors to first protect their core savings by building up an emergency fund and using tax-advantaged retirement savings accounts to invest in a mix of low-cost stock and bond index funds.

Once that’s done, he says there are three main reasons an investor might consider a personalized index:

• Preferences

Although there are already more than 10,000 mutual and exchange-traded funds with almost every imaginable mix of stocks, some investors may prefer to create a portfolio of individual stocks to address ethical or other concerns.

Customization might be limited, though. Customers of Fidelity’s managed FidFolios can jettison up to five stocks or two industries from Fidelity’s preset portfolios; for now, Schwab’s clients can bar only three stocks after selecting a portfolio.

• Balance

Employees of companies that offer significant stock compensation (tech firms, for example) may want to limit tech exposure elsewhere. They could create a personalized index that avoids the tech stocks that make up more than one-fourth of the S&P 500, diversification that could reduce overall portfolio risk.

• Taxes

Investors in high tax brackets who expect to reap significant capital gains can use personalized indexing to turbocharge tax loss harvesting in taxable brokerage accounts. The technique involves selling an investment that has declined in value and using the losses to offset taxes on capital gains from other investments. To stay fully invested, investors use the proceeds to buy something similar.

The boosters say tax-loss harvesting can be worth the work.

But other cost-conscious investment advisers say most investors don’t pay enough taxes to make the strategy worthwhile, unless they expect large capital gains.

(Kim Clark is senior associate editor at Kiplinger’s Personal Finance magazine. For more on this and similar money topics, visit Kiplinger.com.)

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