What Vanguard’s move into direct indexing will mean for advisors and clients

Vanguard, the firm that launched the index fund industry, is now about to launch direct indexing, avoiding ETFs and mutual funds for at least part of the portfolio. As the company announced on July 13, it reached a deal to acquire Oakland, CA based Just Invest, a $1 billion direct indexing provider of SMAs.

While the details of the offering haven’t been released and the deal won’t close until the fourth quarter, here are my thoughts based on the press release and an interview with Vanguard spokesperson Freddy Martino. I’ll conclude with my thoughts on direct indexing as a whole.

Giving the advisor the edge
First, I was somewhat surprised that this future offering will only be made through Vanguard’s financial intermediary business, serving registered investment advisors (RIAs), banks, and broker-dealer financial advisors. Vanguard has been competing with advisors through their Personal Advisory Services (PAS), a hybrid of a robo and human advisory product. Martino confirmed that this announcement excluded any planned direct indexing offering in its PAS business.

This will give advisors an upper hand for those clients wanting direct indexing since it won’t initially be available to any retail investors, which includes those investing directly or through PAS.

What will the offering look like? Some hints might be found by looking at Just Invest’s web site. Just Invest emphasizes a “fair price” and indexing based on “Smart beta factor tilts, SRI screens, ESG scores, UN SDG characteristics, gender diversity metrics.”

Just Invest’s Form ADV Part 2 notes its fee for advisor SMAs is 0.40% annually but negotiates downward for larger portfolios. Looking at the scale of Vanguard’s $3 trillion financial intermediary business, its ability to scale and lower fees is about to take a giant leap. I wouldn’t be surprised to see fees dipping to 0.10% or lower, especially for larger accounts.

Now to be sure, direct indexing has been available to advisors and investors at other custodians like Fidelity and Schwab for some time. I suspect Vanguard will offer lower fees or possibly even set off another fee war. Last year, I wrote that Schwab’s new offering of fractional shares was possibly being a step to direct indexing for the masses at ultra-low prices. In fact, I asked Vanguard then if they had any plans for direct indexing and they responded, “If we believe that there is an enduring investment case for the addition of an investment strategy, and a cost-effective way to implement it, we will consider it.”

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A better mousetrap with drawbacks
I’m on record as saying that “free to ultra-low-cost direct indexing really is a better mousetrap.” It’s a far more efficient way of tax loss harvesting on an individual security level rather than having to sell the whole fund. But it has three big drawbacks. Two of the three big drawbacks are mentioned by Vanguard, which I applaud them for disclosing.

• Direct indexing is subject to tracking error. This is more than the fees since, even if they replicate an entire index to start, it can’t stay that way as the wash sale rule would prevent them from buying back that security until 31 days or longer.
• There may also be unintended tax implications. First understand that the tax savings in the early years is only a deferral of taxes. As long as the securities are eventually sold while the investor is living, capital gains taxes will eventually have to be paid. And if the long-term capital gains tax rate goes up or is eliminated (as being discussed in Congress now), it could backfire.

One additional drawback is that the tax loss harvesting provides the most benefits in the early years. Assuming the market goes up in the long run, the vast majority of the securities remaining after several years are likely to have very large unrealized gains providing very little opportunity to tax loss harvest. Only the costs and complexities remain. One strategy, however, is to use it to tax loss harvest in the first few years and then donate the holdings to a donor advised fund, which would eliminate the taxes on those unrealized gains. Obviously, there must first be a charitable intent.

Regardless of the drawbacks, I’m still intrigued by this announcement. I hope that Vanguard will launch the product with ultra-low fees and follow broadly diversified indices similar to its total U.S. and total international stock index funds.