If you follow investment news closely, a seemingly new strategy may have caught your eye: direct indexing. Read on for the full scoop on what it is, how it works, and whether it’s worth using for your own investments.
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 invest directly in most or all of the securities tracked by an index, instead of investing in an index fund that invests in them for you.
How Does It Work?
Let’s say you have $100,000 you’d like to allocate to the asset class of 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, 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 achieve the same exposure to the same collection of U.S. large-cap growth stocks by investing $100,000 directly in the individual stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index.|
|Management||On your account statements, you would see a single position in one fund representing a U.S. large-cap stock allocation (as proxied by the S&P 500). To hold a larger or smaller allocation to this asset class, you would buy or sell shares of this single fund.||On your account statements, you would see hundreds of different stock positions (or at least enough stocks to accurately emulate the index). You could then individually buy or sell shares from each position to alter your U.S. large-cap stock allocation.|
|Tracking||When the S&P 500’s holdings or weights changed in the index, the fund would alter its underlying holdings as well. To continue tracking the index, you simply keep holding the fund.||When the S&P 500’s holdings or weights changed in the index, you would need to place trades across your individual positions to continue tracking the index.|
|Taxes||When selling fund shares, you’d realize a gain or loss based on how much you paid for each mutual fund or ETF share.||When selling individual stock shares, you’d realize a gain or loss based on how much you paid for each stock share.|
Direct indexing doesn’t have to be an “all or nothing” strategy. It’s more typical to implement it 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 buy and sell components. Direct indexing becomes increasingly impractical in markets where trading is more difficult and/or expensive.
Some institutional and similar large investors have been incorporating direct indexing into their portfolio builds for years, usually through Separately Management Accounts (SMAs). As such, the approach is not new, but it has been receiving increased media coverage lately.
That’s likely because direct indexing has become more practical for individual investors. Recently, many trading platforms have: (1) eliminated investor trading fees that made it cost-prohibitive to buy and sell so many individual securities; and (2) allowed fractional share purchases, making it possible to capture an index’s holdings in smaller slices. As a result, more providers are offering direct indexing services to smaller accounts for relatively modest fees.
Why Do It?
Even if it’s possible to engage in direct indexing at costs approaching those of traditional index fund fees, why not simply go along for the low-cost index fund ride? The potentials are two-fold:
- More Flexible Tax Management: 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 underlying security you hold. For your taxable accounts, 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.
- More Personalized Experience: Direct indexing also offers more flexibility to start with a popular index, and add exceptions based on your personal financial goals. For example, you could use direct indexing to augment a regular indexing approach with a personalized values-based filter (such as adjusting your mix of “virtuous” vs. “sin” stocks). Or, if you’re employed by a company from which you have significant stock options and thus a concentrated position in the company, you might exclude that company from your portfolio to reduce risk you’re already incurring through your employment.
Direct indexing may offer more granular portfolio and tax management than you can get through traditional index fund investing, but any incremental benefits must be weighed against the tradeoffs involved in implementing them. There’s no doubt that the direct indexing strategy is a more labor-intensive, demanding approach to investing. The potential for error and the time required to manage the strategy are both significant. As with any “new” strategy, careful consideration must be given to the question of whether the strategy moves the investor closer to their goals in a sustainable, productive way.
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.
2 - One proponent of direct indexing suggests: “[Y]ou can capture the vast majority of diversification benefits of the S&P 500 by owning the largest 100 stocks in the S&P 500 Index.”