A few weeks ago in a podcast discussion, the expression “letting the cat out of the bag” came up and I thought of the great history book by Robert Darnton The Great Cat Massacre. This caused another cat expression “more than one way to skin a cat” to pop into my mind.
This preface is to stress that we are not about cat hating here at Walkner Condon, but we are dedicated to finding new opportunities for our clients. A great deal of talk about investing for Americans abroad covers all the limits they face, but we frequently overlook the various opportunities that are available to Americans abroad– solutions that weren’t possible twenty or thirty years ago. As my colleague Clint Walkner has commented, “In terms of investment solutions and costs, it is a great time to be an investor.” In this particular blog post (which is adapted from a forthcoming paper on indexing), I’m going to discuss “more than one way to skin a cat” in terms of ways of indexing outside of the traditional index mutual fund or ETF.
Information regarding PRIIPs and KIDs in the European Union means that ETFs– the most popular investment tool in the United States–will no longer be able to be bought or sold by investors in the European Union and is yet another headache for American investors (and you can read more about the topic here and here).
The fact that not all custodians and brokerages have adapted to it at the same speed has left many advisors making various claims about this situation. A great deal of the anxiety is arising because Americans abroad have been led to believe that ETFs are the ONLY way for Americans to achieve low-cost diversification while living outside of the United States. In fact, ETFs are not the only (nor are they necessarily the best) way to invest for Americans abroad. Instead, there are several ways of handling the issue as Clint and I discussed in a podcast on the “Future of Taxable Investing” a few weeks ago.
In our white paper on the topic, we will discuss the various types of compliant investing including SMAs and direct indexing, but in our approach these are (along with ETFs) all part of an overall investment strategy which focuses on tax efficiency and lowering investor fees for best real long-term returns. In an effort to provide some clarity, we’re going to discuss indices and various permutations beyond the ETF and Mutual Fund below.
What is an Index/Indexing?
An index is a collection of stocks that is designed to show the overall performance of a market category. (For a more detailed explanation of this concept of how in, take a look at Investopedia’s article on the topic. https://www.investopedia.com/university/indexes/index1.asp)
Indexing is both the idea of creating this list of stocks and making a product out of an underlying index. As my colleague Nate Condon has described it: “When you walk down the cracker aisle, you can buy sixteen different kinds of saltine crackers. They all have the same underlying recipe. The recipe is the index and the different brands are the various ETFs and Mutual Funds that are available to you.” Indexing is the process of labeling and boxing the crackers made from the same recipe: Vanguard started the process by creating the first ever indexed mutual fund. Since then, multiple companies have started creating indices for every conceivable stock, bond, and commodity index around the world.
In the world of investing, as well, it is important to note that it is the boxing and packaging and not the recipe that is regulated. So we’ve seen regulations from the US come to be enforced on restricting the sales of mutual funds outside of the United States and the EU put regulations on mutual funds and ETFs that have come to restrict their portfolios as well.
As an index is a list of stocks, it doesn’t necessarily have to come in the form of an ETF or a Mutual Fund and the recent developments in the world of indexing means that it isn’t necessary.
What is Direct Indexing?
Direct indexing, which has been a hot topic among investors since it was discussed at the Inside ETFs conference in February 2019, is simply going out and buying the underlying stocks that are represented on an index. This was traditionally done for large institutional clients, because the transaction costs of buying individual shares were too much for individual investors, buying even to buy one share of each stock in a portfolio to mimic the S&P 500 would require about 60,000 USD along with about 2000 USD in trading costs. However, as brokerage costs have lowered and the possibility of owning “fractional” shares (that is less than one whole share of a stock) has emerged, an individual investor can now purchase a direct index for as little as 5000 USD and .08% in ongoing fees, plus some low introductory trading costs. One of the reasons we have selected Interactive Brokers as our custodian and broker, is because they have been pioneering the use of offering “Direct Indices” to their clients. This is a solution for investors in the EU that wouldn’t have been possible before.
What is a SMA?
As I describe in our white paper “Are You KIDing Me?: PRIIPs, KIDs, and New Obstacles for Americans Buying ETFs in the EU”:
There is an additional solution for Americans considering their money management options: separately managed accounts or “SMA”. A separately managed account means that investors hold individual stock positions that are managed by an outside money manager. Such a manager may also run a mutual fund with a similar strategy, but an SMA allows for further customization.
In other words, if you set up a separate account with Money Manager X, then Manager X has the discretion to make decisions for this account that may be different from decisions made for other accounts [managed by the same Money Manager X].
One of the ideas that have taken root over the last ten years is that active management is bad. And for most investors the switch from actively managed, high-cost, tax-inefficient mutual funds to passively managed, low-cost ETFs has been a smart one. However, this ignores that not all “active” management is the same and that certain indexing solutions can be “improved” via active management in order to lower overall tax liability and improve after tax performance (remember the research shows that active management trails indices after taxes and fees, not before). One such strategy is employed by Parametric (an SMA we use) which specializes in low-cost direct indexing SMAs to use active management to lower tax bills— and provide results that are superior to ETFs (see their white paper “Tax Managed SMAs: Better than ETFs?”).
I’ve always explained that good investors have a plan and they stick to it, but sometimes the world changes and sticking to your plan means sticking your head in the sand. The advent of direct indexing means that smart investors with smart advisors don’t need to abandon their plan as global financial regulations change. One of our core values at Walkner Condon is to embrace change so that we find the solutions that work for you in light of the ever changing regulatory environment: if the world is changing and your plan isn’t…Set up a no-cost, no-obligation appointment with us to schedule a meeting with Keith to explore your investment and financial planning options.