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Direct Indexing: Beware of the Complexities

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Why do people invest? We believe the best reason to invest is to create or preserve enough wealth to fund your future goals. An additional, immediate reward comes from the tranquility you feel today, knowing you are building a dependable financial safety net to protect yourself against tomorrow’s unknowns.

This leads to a critical understanding: You and your ideal investments must not only start out strong. They must have the stamina to last.

We’re not yet convinced direct indexing is the best solution for this essential duty. The complexities involved may make it harder rather than easier to build, manage, and stick with your ideal low-cost globally diversified investment portfolio, tailored to reflect your personal financial goals and risk tolerances.

Course Corrections

Effectively tracking an index over time isn’t as simple as it may sound. Like trying to walk across a swaying bridge on a spinning planet, everything is in constant motion. Managing all the movement (and reporting it on your tax returns) can leave you dizzy.

  • Reconstituting: The index you’re tracking periodically reconstitutes its holdings, removing companies that no longer best represent its target asset class, and adding ones that do. To continue tracking the index, you’ll need to shift your holdings as well.
  • Rebalancing: Markets move too. To sustain your investment allocations, you’ll periodically buy more of the recently underperforming assets and sell some of the recent winners.
  • Reallocating: Your own financial goals may also evolve over time, calling for a shift in your underlying allocations. This too requires additional trades, to stay on track with your goals.

Tax Entanglements

With traditional index investing, if you (or your advisor) 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 service provider might need to place hundreds of trades, several times a year. Each trade becomes a line item you and your accountant must accurately track and report come tax time.

Active Temptations

What if you’re using direct indexing to make individual exceptions to a standard index fund or similar asset-class approach? This generates additional layers of complexity, which can make it harder to stay on course toward your desired destination.

  • If you’re no longer closely tracking indexes or similar standardized benchmarks, at what point do you lose control over understanding your portfolio-wide risks and expected returns?
  • How do you make sensible adjustments over time, without throwing your portfolio’s carefully structured asset allocations out of whack?
  • Will you succumb to tracking error regret, and lose your stamina if your portfolio underperforms its closest benchmark (even if it’s expected to)?
  • Why are you making the exceptions to begin with? If it’s to bring your total portfolio closer to its intended asset allocation, it might make sense. If you believe you know more than the market does about what lies ahead, you’re no longer investing; you’re speculating.

Operating Efficiencies

By building your portfolio using well-managed, low-cost index or similar asset-class funds, you’re essentially hiring a professional to manage many of these complexities for you. The complexities don’t necessarily go away, but most of them happen behind the scenes. Especially over time, this offers 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 quality fund manager can also often add value to your experience. For example:

  • A fund manager’s economies of scale may offer them more leverage than you have as an individual investor. This can help them trade more patiently and cost-effectively when an index undergoes reconstitution, or market prices are swinging to extremes.
  • You can find global core funds that replicate a typical asset-allocated portfolio for you—including taking care of rebalancing it over time.
  • Some fund managers offer tax-managed versions of their funds.
  • These days, there are a growing number of solutions for those who would like to integrate sustainable, ESG (Environmental, Social, and Governance), or other values-based investing into their structured portfolios.

Simple, Sensible Success

Investment success comes from investing according to a plan that makes sense to you. It also should make sense for you, given your goals. It should increase your ability to build the wealth you need, while managing the risks involved. As important, it should be simple enough to stick with—basically forever.

At least on paper, direct indexing offers some of these qualities. But why try to dismember an efficient machine into its individual parts? For the vast majority of investors, we can deploy a simpler, cost-effective, funds-based approach to closely track your personal financial goals. As “Fortunes and Frictions” investment blogger Rubin Miller said in an investment lessons post:

“Successful investors architect successful outcomes. An often under-respected element of elite investing is that more effort typically leads to worse outcomes.

If you want to be an elite doctor or lawyer – wake up early, study hard, try to attend great schools. But if you want to be an elite equity investor, simply buy the global stock market for a low cost, and get the hell out of the way.”

Please be in touch if you’d like to learn more about our evidence-based approach to portfolio management.

 

CLICK HERE for Part 1 on Direct Indexing.

 

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Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.

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