Over the last few years, our team at Values Added has become increasingly excited about a newly-accessible approach to investing: personalized indexing.
This creative approach allows for more precise social impact screening and, when used in the right situation, has powerful tax advantages.
At Values Added, we leverage personalized indexing for several of our clients – and it has several clear benefits.
In this blog, we’ll be going over:
- The pros and cons of personalized indexing
- Who it’s for
- Who may not be a good fit for this strategy
- Why we use it as a financial planning team
Read on to learn about what personalized indexing is, who it tends to make sense for, and why it’s more accessible than before.
What is it?
Personalized indexing is a way to invest in the stock market. It is similar to investing through a mutual fund or ETF, but instead of owning shares in a big fund along with millions of other people, you buy the underlying stocks directly. You can still have broad diversification by including lots of companies in your portfolio, but also get more autonomy in how you (or your advisor) build your portfolio.
With personalized indexing, you also get the ability to change your investments based on changes to your situation or preferences because, unlike a mutual fund which is the same for everyone, you/your advisor can adjust your personalized indexing investments to precisely reflect your needs at any given time.
You purchase individual securities that statistically approximate a specific index. For example, you might choose to approximate the S+P 500, a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States. You don’t need to buy all 500 stocks because you can achieve a very high correlation with the index while holding many fewer positions.
What are the main benefits?
People using personalized indexing can:
- Buy and sell individual securities to maximize tax savings
- Sell specific securities that no longer align with their values
- Avoid specific companies if needed for compliance, ethics, or other reasons
- Generate positions that are well-suited to donating to charity
Personalized Indexing v. Traditional Index Funds
There are several key differences between traditional index fund investing and personalized indexing.
Here are a few big items to consider:
Tax benefits. Because you can use personalized indexing to sell off individual securities, you can typically do way more tax-loss harvesting. A recent study found between 2.5x and 4x more opportunities to tax loss harvest with personalized indexing than with mutual funds/ETFs.
This tax-loss harvesting can meaningfully lower taxes because it may allow future stock selling without additional taxes due, reduce ordinary income by $3,000 per year, and also can reduce capital gains from other areas like home sales or some kinds of equity compensation. Plus, personalized indexing can also help concentrate positions, enabling tax benefits for people who give to tax-deductible organizations.
Cost. Although there are significant tax benefits, there are also notable cost differences to consider. Most people who use personalized indexing need help with the statistical analysis necessary to select a good subset of stocks. Depending on your provider and the features or functions included, you could be looking at anywhere from 10-40+ basis points.
Some custodians will charge transaction costs and for some securities and the trades can have some other costs too. We use Ethic, our clients pay them 20-30 basis points and do not generally pay any trading fees at Schwab for these stock trades. With that cost structure, in the right situations, the additional tax savings can far exceed the costs. Of course, every investor should get advice and evaluate their own situation to determine whether this is worth it for them. Situations vary and our past experience won’t necessarily be the same as what happens in the future.
Customization. Personalized indexing comes with the ability to do a massive amount of personal customization–a person could make decisions on thousands of securities if they wanted too. This allows impact-oriented investors to individually screen for different ethical criteria. Generally, our clients use Ethic to do the screening for them, but they can also further customize by choosing companies to be on a specific no-trade list if they wish.
For instance, say you want to avoid most fossil fuel companies but do want to invest in ones that have significant investments in green energy. You can’t generally do something that precisely tailored with an ETF, but could with personalized indexing. Likewise, if you want healthcare and pharma firms but not opioid manufacturers, you can also do that via personalized indexing. Personalized indexing can also allow you to avoid specific industries or companies, either due to personal preference or legal/professional obligations.
Personalized indexing also gives people the power to sell off securities if their views change about a company, for instance they read an investigative report that the company has committed human rights violations. Mutual Fund and ETF investors, on the other hand, have the much tougher choice of whether to ignore the new information or to sell the whole fund and pay taxes on any gain if they want to divest themselves (assuming the fund managers haven’t chosen to sell the company).
Who is Personalized Indexing For?
At Values Added, we typically look if one or more of these criteria are present to see if personalized indexing is a potential avenue to explore for a specific client.
Are they values-aligned investors?
Because personalized indexing has so much customization available, values-aligned investors who:
- want to be extra intentional about which companies they invest in
- want the ability to update their portfolio as they learn more about different companies, and world events and keep their portfolio aligned with their values and priorities as they change over time
- love the flexibility personalized indexing has because no-trade lists make it easy to exclude specific companies or industries, and can be edited anytime.
Do they want to pay less in taxes, and are they in a higher tax bracket?
Personalized indexing means more flexibility in buying and selling specific securities – which can lead to more flexibility in tax strategy. For those who are in a higher tax bracket (or at least higher than usual for them), and want to offset some of their taxes, personalized indexing can allow them to leverage both tax-loss harvesting and tax-efficient donation options.
If you plan to leave most of their portfolio to your heirs or charities you can also benefit even more from personalized indexing. That’s because the portion of the portfolios you don’t sell or donate during your life gets a step-up in basis when you die, so capital gains taxes are not owed on that portion of your portfolio growth.
Do they have concentrated stock positions to contend with?
Having concentrated stock as a startup founder, high-level executive, or long-term investor can seriously complicate your investing needs. Personalized indexing allows you to offset the concentration by specifically screening out companies or industries that would duplicate your concentrated holding. For example, currently, approximately 7% of the S&P 500’s value is Microsoft. So, if an investor is already over-concentrated in Microsoft stock, buying an S&P fund isn’t going to do as much diversification as they’d like because roughly 7% of each dollar invested in the S&P 500 will be invested in Microsoft.
Personalized indexing allows them to focus their new investments on the other parts of the S&P 500 to avoid duplicating their existing investments in Microsoft. If they prefer, with personalized indexing, they can even make sure new investments avoid other companies that are highly correlated with Microsoft.
Are they charitable?
Personalized indexing enables a super-charged tax strategy. Donating appreciated stock is a great way to support charities while also avoiding paying capital gains taxes on the appreciation. With a mutual fund or ETF, the appreciation is the average of all the companies in the fund, so tends to be only some of the value of the security. With individual companies, it’s common for long-term investors to hold and donate stocks that are more than 90% appreciation, supercharging this strategy.
Will they be making new investments?
Personalized indexing’s tax advantages are often the most pronounced in the first few years that dollars are invested. This means it is particularly effective for people who tend to invest new money over time. For instance someone who pursues FIRE (“Financial Independence, Retire Early”) may invest new money every month. Even investing every few years would work well.
Speaking personally, in my household, we save and invest money in a taxable account in most years and we also give charitably (currently about 20%) each year. This pattern of frequent contributions and new investments is a great fit with personalized indexing, which is why I use it personally for my taxable US investments.
Who Isn’t Personalized Indexing For?
Although personalized indexing can be fantastic, and is often an underused tool in the investing space, there are certain situations where it just doesn’t make as much sense.
It’s extra work. If you manage your own portfolio this is probably too much to do on your own without additional tools. There are tools built for DIY investors who want to use personalized indexing without a comprehensive advisor, but they typically aren’t free. It can also increase your tax-filing complexity, which may mean slightly higher fees from your tax professional.
If you plan to be in a higher tax bracket later in your career or retirement, personalized indexing may not be as beneficial from a tax perspective. Tax-loss harvesting can sometimes increase taxes for those who are in a low-tax bracket now and end up in a much higher tax bracket later. So, while you can still do personalized indexing, you’d need to consider holding off on the tax-loss harvesting part of the strategy.
For example, if you’re a pre-seed startup founder currently paying yourself a low salary but you plan to increase it significantly in the next few years and will quickly be in a much higher tax bracket, it’s especially important to get good tax advice on whether to hold off on tax loss harvesting for now. While the tax savings in your lower bracket years are more modest, even in this situation, it is sometimes worth it to harvest losses so that you can rollover those losses to future years might help significantly, especially if you incur capital gains as part of your exit strategy. It’s a delicate balance.
Conflict of interest rules can complicate things. If you have workplace-based conflict of interest rules or investment limitations, personalized indexing may require more work to implement. Personalized indexing can be very helpful if a person isn’t allowed to invest in a few specific companies, but if your work might touch on many different companies, then safe harbors for investing through mutual funds may be worth using instead of this strategy.
For instance, if you work in certain areas of government, personalized indexing could potentially complicate decisions about conflicts and recusals since you would probably own a lot of individual stocks of companies that may be affected by government action. Also, if you have to do the more detailed federal financial disclosures, personalized indexing can add a lot of lines to your report.
As always, it’s best to consult with the relevant ethics/compliance team to understand how to correctly apply the rules. Your advisor may be able to help with this coordination (we happily do so for our clients, for example).
Personalized indexing only provides tax advantages with taxable investments. So, retirement funds like 401k accounts and college funds like 529s aren’t usually a great fit for this approach. Personalized indexing is a more natural fit for people with taxable investments.
Personalized indexing can be more costly to implement for non-US investments. Many custodians (the place where you have your investment account, Fidelity or Schwab for example) charge for trades in non-US securities such as companies listed on European, Asian, or other stock exchanges. As a result, you might have to pay several dollars per trade on non-US securities and this can make the strategy go from a great choice to a less obvious one. We generally don’t recommend that our clients use personalized indexing for investments in non-US companies.
Bigger portfolios fit better with a personalized indexing strategy. If you’re still in growth mode, personalized indexing may be a fit in the future. Typically, personalized indexing requires higher investment minimums than investing in ETFs and mutual funds. These minimums have been coming down, but many providers require $200,000 or more.
This means it isn’t a fit yet for most Americans. The benefits you’ll create are more significant when your portfolio balance is higher and also when you can avoid selling the most appreciated securities. But technology and competition (as well as the increasing availability of fractional shares) are bringing down minimums and as that happens this approach becomes more accessible to more people.
Why Now?
Personalized indexing has been around for a while, but in recent years, new providers have come onto the scene, introducing lower costs, better ethics data and proxy voting, and lower investment minimums. This has opened up personalized indexing to investors who previously may not have been a perfect fit.
What’s Next?
We’ll be digging deeper into different personalized indexing benefits, and how the Values Added team leverages this strategy, in the coming weeks! If you have any questions you’d like us to try to answer in an upcoming blog in this series, send me an email at zach (at) valuesadded.com.
Always consult a financial, tax, or legal professional familiar with your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any rates of return are historical or hypothetical in nature and are not a guarantee of future returns, which may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions and security positions, when sold, may be worth less or more than their original cost.