Direct indexing used to be an investment strategy long associated with the ultra-wealthy. Today, it has become accessible to a broader audience due to advancements in financial technology. In simple terms, direct indexing involves owning individual stocks that replicate a market index, rather than buying a mutual fund or ETF that tracks it. This gives the investors complete ownership and control of the underlying companies in their portfolio, unlike traditional index funds.
Let’s understand direct indexing with the help of an example. Instead of purchasing the SPDR S&P 500 ETF (SPY), an investor holds some or most of the 500 stocks that it comprises of, optimized to match the performance of the underlying index.
How Direct Indexing evolved?
Direct indexing was primarily reserved for investors with a substantial pool of money, typically $250,000 or more, to invest, as owning and rebalancing hundreds of individual stocks was both expensive and complex. However, with the advent of growing innovations in the realm of investing, the scenario has changed completely. With the availability of zero-commission trading, automated rebalancing algorithms, and fractional shares, direct indexing is now a strategy that is affordable for even everyday investors. In today’s market, even investors with limited funds can access a fully personalized and tax-efficient portfolio that mirrors major indices, and do so with their own flexibility.
Why Direct Indexing Matters
As every trend becomes popular, direct indexing has also gained traction, but it is not only because it is a new strategy for the everyday investor. It matters because it solves problems that have long troubled traditional mutual-fund and ETF investors.
Ultimate Personalization: A mutual fund or an ETF gives investors an option to invest in a pre-decided basket of stocks. But what if the investor doesn’t want to include certain stocks in their portfolio due to personal and ethical preferences, or conversely, wants to definitely include certain stocks because of a keen inclination towards them? Direct indexing solves this problem by allowing the investor to customize their portfolio according to their personal values and goals. Investors have the choice and flexibility to exclude stocks of the companies they do not support, overweight the ones they strongly believe in, or focus on specific factors – all while still tracking a broader benchmark. This level of personalization makes direct indexing more preferable compared to traditional index investing.
Enhanced Transparency and Control: When an investor invests in an ETF or a mutual fund, they take one step back from knowing their actual holdings. They can track the fund’s performance, but not the performance of the individual stocks that make up the fund. Additionally, it deprives them of detailed insight into every underlying trade or cost basis. Direct indexing gives you the full right and authority as you own each stock outright. The investor can have real-time knowledge about what they hold, how it is performing, and how the real-time gains and losses look. This transparency and control empower investors to make informed decisions and align their investments with their financial plan.
Tax Efficiency and Loss Harvesting: Traditional index funds are tax-efficient only up to a point. The investor does not have the liberty to decide when to sell the individual holdings that comprise the funds. This leads to a missed opportunity to realize losses when certain stocks underperform. Direct indexing changes this narrative. Since the investors own the actual stocks, they can take advantage of tax-loss harvesting by strategically selling losing positions to offset gains elsewhere. The realized amount is then reinvested in similar but not identical securities to maintain the same level of market exposure. This helps improve after-tax returns and reduce annual tax bills, depending on individual tax brackets and market conditions. This is one feature that makes direct indexing one of the most tax-efficient investment strategies in the current times.
Potential Downsides
Like any other investment strategy, direct indexing also has its own downsides.
Advisory Costs: Unlike ultra-low-cost ETFs, direct indexing typically involves an annual advisory or management fee that the provider charges, and this can range from 0.15% to 0.35%, making it comparatively costlier.
Minimum Investment Requirements: Some providers have minimum investment requirements for direct indexing that can restrict investors from implementing this strategy.
Complexity: Although modern platforms have automated many tasks, managing hundreds of positions can still feel overwhelming and complicated for some investors.
Tracking Deviation: While direct indexing provides the flexibility to customize the choice of stocks, too much customization can lead to returns that diverge from the benchmark (known as “tracking error”).
Who Should Consider Direct Indexing?
Direct Indexing is ideal for those who invest primarily in taxable accounts. It is an excellent choice for those who want customizations and care about value-based investing, which includes ESG (Environmental, Social, and Governance), social impact, or specific sector preferences. Direct indexing offers an excellent evolution of passive investing for investors who have a long-term horizon and want to take a tax-smart and transparent approach.
How to Get Started?
Following this roadmap will help anybody get started comfortably with direct indexing:
- Picking up the appropriate platform based on personal requirements. The investor should compare the platforms based on minimums, fees, and tax features. Some of the famous platforms that offer direct indexing are Public.com, Fidelity, and Charles Schwab. While Fidelity and Charles Schwab have strong brand credibility, Public.com stands out for its transparent pricing and accessibility.
- Selecting the benchmark that best reflects the investor’s personal goals and choosing an index, such as the S&P 500 or NASDAQ 100, accordingly.
- Customizing the portfolio is essential for adding or excluding stocks or specific sectors based on the personal and ethical preferences of the investor.
- Enabling tax-loss harvesting by allowing the platform to realize losses when the market fluctuates automatically.
- Monitoring and rebalancing the portfolio involves periodically reviewing it to maintain index alignment and tax efficiency.
The future of investing is personalized and automated. Direct Indexing merges the efficiency of passive investing with the customization of active management. It gives investors more than just market exposure – it gives them ownership, flexibility, and control. It would not be wrong to say that for investors who prioritize tax efficiency and want their portfolio aligned to their personal interests, direct indexing is not just a short-lived trend but a long-term evolution in how modern investors build wealth.
