Our Take on Direct Indexing
Submitted by Desmond Wealth Management, Inc. on August 23rd, 2022Just when you thought there were no more financial innovations to be made, a (sort of) new one has been receiving extra attention lately in the financial press: direct indexing. If you’ve read about it, you may be wondering what it is, how it works, and whether you should consider it for your own investments.
Before you decide to jump on this or any other investment bandwagon, we recommend weighing the advantages and disadvantages involved. Based on our assessment, we believe there are times when direct indexing might help address particular challenges for individual investors. However, it is better suited for targeted applications than for being a “one size fits all” solution.
Part 1: What Is Direct Index Investing?
Direct index investing shares some traits with its more familiar cousin, index fund investing. A traditional index mutual fund or exchange-traded fund (ETF) buys and holds the securities tracked by a particular index, which in turn seeks to replicate the performance of a particular slice of the market. For example, the Vanguard S&P 500 ETF (VOO) tracks the S&P 500 Index, which approximately tracks the asset class of U.S. large-company stocks.
In direct indexing, you typically invest directly in a representative sampling of the securities tracked by an index, instead of investing in an index fund that invests in them for you. The goal is to hold enough individual securities to track a target index or factor as close as possible while adding the potential for extra flexibility through additional, security-specific trading possibilities.
However, extra flexibility also adds extra complexities, calling for a cost-benefit analysis on whether the tradeoffs are worth it.
How Does Direct Indexing Work?
Let’s say you have $100,000 you’d like to allocate to U.S. large-company stocks, as proxied by the S&P 500. Here’s how you or your investment manager might proceed:
As an Index Fund Investor… |
As a Direct Indexing Investor… |
|
---|---|---|
Set-Up |
You could buy $100,000 worth of an S&P 500 Index fund or ETF, weighted by market cap. You would then indirectly hold all U.S. large-company stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index. |
You could invest $100,000 directly in the individual U.S. large-cap stocks tracked by the S&P 500 (or at least enough of them to accurately “sample” the index), in similar allocations to each stock’s weight in the index. |
Tracking | When the S&P 500’s holdings or weights change in the index, the fund would alter its underlying holdings as well. To continue tracking the index, you simply keep holding the fund. | As the S&P 500’s holdings or weights change in the index, you or your investment manager would need to place trades across your individual positions to continue tracking the index. |
Fees | Index funds usually charge a fee to manage the fund and trade its underlying holdings for you. Typical fees range from as low as 0.02%–0.04% for a plain S&P Index fund, upward. | Direct index providers usually charge a fee based on the services they’re offering (which can vary widely). We’ve seen typical fees ranging from 0.12%–0.25%, upward. |
Minimums |
There are typically no, or very low minimums required to invest in an index fund. |
Depending on the direct index provider, investment minimums can range between a few thousand to a few hundred thousand dollars to get started. |
Taxes |
When selling fund shares, you realize a gain or loss based on how much you paid for each mutual fund or ETF share. |
When selling individual stock shares, you realize a gain or loss based on how much you paid for each individual stock share. |
Direct indexing is rarely an “all or nothing” strategy, especially since it becomes increasingly impractical to apply it in thinly traded markets. It’s far more typical to implement direct indexing for the portion of the portfolio allocated to highly liquid asset classes, such as U.S. large-cap stocks, where it’s easier to routinely trade individual securities.
Why Now?
Some institutional and high-end investors have been incorporating direct indexing into their portfolios for years, usually through Separately Managed Accounts (SMAs). As such, the approach is not new, but it has received increased attention lately. That’s likely because direct indexing has become more approachable for individual investors, as trading platforms have:
- Eliminated trading fees, making it cost-effective to frequently buy and sell smaller lots of individual securities.
- Allowed fractional share purchases, making it possible to capture an index’s holdings in smaller slices.
Thanks to these innovations, more providers can offer direct indexing to smaller accounts for relatively modest fees, but just because you can engage in direct indexing, should you?
Part 2: The Downsides to Direct Indexing
Relative to a mutual fund or ETF investments, there are advantages to direct indexing. We’ll turn to these in a moment, but before we describe scenarios in which the approach may be beneficial, let’s cover why direct indexing isn’t for everyone.
Course Corrections
Effectively tracking an index over time isn’t as simple as it may sound. The index itself reconstitutes its holdings periodically, even as you might need to rebalance or reallocate your own mix of various assets in your portfolio. Combined, these requirements can generate a lot more trading for you or your investment manager to effectively manage.
Tax Entanglements
With traditional index investing, if you harvest tax losses or incur taxable gains to rebalance or otherwise manage your portfolio, you’ll trade a few funds, and report the results on your annual return. To accomplish these same tasks with direct indexing, you or your investment manager might need to regularly place hundreds of trades to track and report come tax time.
Operating Efficiencies
By building your portfolio using a well-managed, low-cost index or similar factor-based funds, you’re essentially hiring a professional to manage many of these complexities for you. The complexities don’t necessarily go away, but far more of them happen behind the scenes. This can offer a cleaner view of where you’re at and where you’re headed, which can in turn make it easier to maintain your investment stamina. A professional fund manager may also enjoy cost-saving economies of scale to add more value to your bottom line.
Active Investment Temptations
The more you use direct indexing to tinker with a standard index or similar factor-based portfolio, the more you may lose sight of your overall risks and expected returns and, in turn, your carefully constructed asset allocations. Why are you making the exceptions, to begin with? Is the goal to keep your total portfolio close to its intended asset allocations and evidence-based factor exposures, while pursuing some of the benefits described below? In that case, it may make good sense. If you start hoping or believing you know more than the market does about what lies ahead, you’re no longer investing; you’re speculating.
Direct Indexing in Context
The bottom line, “if it ain’t broke, don’t fix it” applies well here. Before including direct indexing in your investments, ask yourself: Will the expected benefits not just match, but exceed those you can already achieve through a portfolio of well-managed, tax-efficient, low-cost index or factor-based funds? If the answer is, “probably not,” it’s probably not worth the effort.
Again, direct indexing is likely best deployed to complement rather than replace all of your index or factor-based funds, especially among smaller asset classes that aren’t as widely traded.
Next, let’s look at some of the ways direct indexing can sometimes add value.
Part 3: Potential Applications for Direct Indexing
We would suggest there are three ways investors can harness direct indexing to:
- Generate additional tax efficiencies.
- More effectively incorporate their personal values (expanding on ESG investing).
- Customize portfolios to manage individual circumstances.
Generating Tax Efficiencies
If you invest in index mutual funds or ETFs, you can only incur gains/losses on the fund’s share price. With direct indexing, you can trade on each individual security you hold. Direct indexing thus offers more flexibility to manage when and how to incur taxable gains and losses, with an eye toward reducing your lifetime tax liabilities. Essentially, your aim may not be to eliminate taxable gains entirely, but rather to incur more of them when your tax rates are lower, and fewer in the years your tax rates are higher.
Illustration #1 – Tax-Loss Harvesting in Taxable Accounts: If you hold an index or factor-based fund, the entire fund must underperform the price at which you purchased its shares before you can harvest a capital loss and use it to offset upcoming taxable gains. With direct indexing, even when the overall underlying index is doing well, you or your investment manager can still identify and potentially harvest select securities in that index that are underperforming the rest. (This activity comes with a caveat, however: Studies have found that harvesting losses more typically defers rather than eliminates taxes unless the portfolio is incurring ongoing short-term capital gains, receiving regular capital inflows, and/or distributing appreciated stocks to charity.)
Illustration #2 – Tax-Wise Charitable Giving From Taxable Accounts: Similarly, to “erase” a capital gain by donating a highly appreciated fund to charity, the entire fund must be worth more than you paid for it. With direct indexing, some individual securities will likely have thrived, even in down markets. You are thus likely to have more opportunities to donate appreciated holdings — either as a one-off event or as part of an ongoing planned giving strategy.
In short, direct indexing can generate more opportunities to make tax-wise trades throughout your lifetime.
Conditions to Consider: Using direct indexing to enhance tax management may be best suited for investors who:
- Hold enough wealth in their taxable accounts to generate meaningful results.
- Are in a sufficiently high tax bracket to warrant extra tax-loss harvesting efforts (such as an owner selling their business or others anticipating large capital gains that could be offset through tax-loss harvesting).
- Are in a low-income year (with a low capital gains rate) to warrant extra tax-gain harvesting.
- Are managing their portfolio to optimize tax-loss harvesting activities, as described above.
- Don’t have other tax-wise moves that might generate even more favorable outcomes.
- Won’t mind tracking and reporting heavier trading activity on their tax returns.
Incorporating Personal Values
Taxes aside, some investors have turned to direct indexing to better align their investments with their personal values. In “Your Essential Guide to Sustainable Investing,” Larry Swedroe and Sam Adams explain:
“Because the investor has decision-making power over the holdings in their [SMA or direct index] account, they can choose to include or exclude any particular type of product, or company, sector, or country, and thus are able to express their values to a very specific level.”
Conditions to Consider: Using direct indexing to invest more sustainably may be best suited for investors who are:
- Highly committed to specialized causes (beyond what an increasing number and growing range of ESG and other sustainable investment funds already offer).
- Able to tolerate additional tracking error when their portfolio deviates from standard index- or factor-based benchmarks.
- Especially willing to prioritize investing according to their values over pursuing the broad market’s highest expected returns.
Customizing Portfolios to Manage Individual Circumstances
Ideally, each of us could create our best investment portfolio from scratch. More realistically, most of us arrive at efficient investing with existing baggage. Direct indexing can help you better integrate various assets into a more unified whole.
Illustration #1 – Temporarily Managing Concentrated Positions in Your Portfolio: You already hold individual, highly appreciated stocks in your taxable portfolio. You’d like to reduce the concentration risks by diversifying away from them, but you’d incur burdensome tax bills if you sold them all at once.
Illustration #2 – Permanently Managing Concentrated Positions in Your Portfolio: You own individual securities or assets you intend to hold indefinitely to bequeath to your heirs, such as a stake in the family business, or stocks that will receive a step-up in basis upon inheritance.
Illustration #3 – Offsetting Your Human Capital “Investment”: You work for, and perhaps hold equity compensation in a company or industry that’s also a significant presence in your ideal investment portfolio (such as technology or energy).
For these and similar scenarios, you might add a direct indexing layer, which would give you more flexibility to invest around the concentrated position, instead of treating it as an outlier. By holding an asset class through direct indexing instead of as a mutual fund or ETF, you could dial down individual stocks or sectors within that asset class’s allocations, to offset existing positions.
For example, let’s say you work for Apple, and/or you hold a large position in its stock. If you’re invested in a standard large-cap growth fund, the index is the index, Apple and all. By using direct indexing for some or all of your U.S. large-cap growth stock exposure, you could dial down your additional exposure to tech stocks in general or Apple in particular.
Conditions to Consider: Using direct indexing to customize for concentrated positions may be best suited for investors who:
- Have concentrated holdings that are significantly relative to the rest of their portfolio.
- Have concentrated holdings within a sector or asset class that’s located in frequently traded markets that can be efficiently tracked by direct indexing.
- Don’t have other, even better strategies for minimizing concentration risks (such as through high-end estate planning or targeted insurance applications).
- Won’t mind tracking a collection of underlying securities instead of a single fund.
Direct Indexing: Is It Worth It?
Until recently, the ability to engage in direct indexing was limited to affluent investors with sizeable portfolios. With the elimination of trading fees and the ability to purchase partial shares in company stocks, direct indexing has become more cost-effective for smaller portfolios. Service providers have seized this opportunity to offer a growing number of relatively affordable direct index services to wider audiences.
Properly applied, direct indexing may offer more granular portfolio and tax management than you can achieve through traditional index or factor-based funds alone. It can help you generate additional tax efficiencies, more effectively incorporate your personal values into your investment activities, and customize your portfolio to manage individual exceptions.
That said, direct indexing is still not appropriate all the time, for every investor. It still adds a layer of complexity that may or may not be warranted. Its costs may or may not pencil out for you and your circumstances. It may help or hinder the disciplined investment stamina you’ll need to pursue your long-term investment goals across various market conditions.
Bottom line, if you’re considering adding direct indexing to your portfolio, you’ll want to determine not only whether it’s an acceptable solution, but whether it’s the best one available for you and your financial goals.
That’s where we at Desmond Wealth Management would love to assist you. We can sit down with you to go over your particulars, answer your additional questions about direct indexing, and help you arrive at a portfolio management solution that makes the most sense for you.
Contact us today to get started.
1. As index investing has proliferated, so have more exotic indexes, tracking trends such as fine wine or Canadian cannabis. For our purposes, we are referring to traditional indexes, tracking broadly recognized market asset classes.