Our Take on Direct Indexing Part 1: What Is Direct Indexing?

Before you decide to jump on this or any other investment bandwagon, we recommend weighing the advantages and disadvantages involved. Once you do, you are likely to find other, preferred ways to invest toward your personal financial goals.

But first things first …

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.[1] 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 represented by the S&P 500. Here’s how you or your investment manager might proceed:

 Set-Up

As an Index Fund Investor … You could buy $100,000 worth of a 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.

As a Direct Index Investor … 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

As an Index Fund Investor … In your account statements, you would see a single position in one fund representing a U.S. large-cap stock allocation (as represented 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.

As a Direct Index Investor … In your account statements, you would see hundreds of different stock positions (or at least enough stocks to accurately emulate the index).[2]  You could then individually buy or sell shares from each position to alter your U.S. large-cap stock allocation.

Tracking

As an Index Fund Investor … 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.

As a Direct Index Investor … When the S&P 500’s holdings or weights change in the index, you will need to place trades across your individual positions to continue tracking the index.

Taxes

As an Index Fund Investor … When selling fund shares, you’d realize a gain or loss based on how much you paid for each mutual fund or ETF share.

As a Direct Index Investor … 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.

Why Now?

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:

1.     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.

2.     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 in a hot sector such as technology, you might reduce some of your exposure to that sector, to offset the concentrated risks you’re already incurring by way of your career.

Is It Worth It?

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. We also must determine not only whether direct indexing may be an acceptable strategy, but whether it’s the best one available.

On both counts, we’re not as enthused by direct indexing as we are by our current funds-based approach to helping investors work towards their long-term financial goals.

Our concerns can be captured in one word: stamina. Your ideal investment portfolio must not only start strong; it must be built to last. In our next piece, we’ll take a closer look at why we’re not yet convinced direct indexing is the best strategy to that challenge.

[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.

[2] One proponent of direct indexing suggests: “You 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.”

Look forward to investing - with WealthBuilders.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and may not be invested into directly.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. No strategy assures success or protects against loss.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors. Stock investing includes risks, including fluctuating prices and loss of principal.

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor