Direct indexing gives investors the ability to mimic the performance of an index such as the S&P 500 by purchasing its underlying stocks to create a customized portfolio. Since you can’t invest directly in an index, most investors will buy an exchange-traded fund (ETF) or mutual fund to replicate its performance.
When you own shares of an index fund such as SPY, you own the stocks indirectly, in the same percentage amount as the index. Alternatively, with direct indexing, you’d buy a representative sample of all those stocks. It’s become an increasingly popular strategy with investors that allows one to invest directly in the individual components of a given index.
Direct Indexing in View
It’s usually not necessary to own every stock in an index to approximate its performance. With direct indexing, investors have direct ownership of the individual stocks in their portfolios. Because of this, they are given opportunities for tax efficiencies and personalization that’s not possible with ETFs and mutual funds.
Technological factors and competition have driven trading costs to near-zero over the years. The ability to trade fractional shares is also now possible. These factors have been a contributor to the popularity of direct indexing and its availability to a broader array of investors. In fact, direct indexing is on track to grow faster than both ETF and mutual fund flows over the next several years.*
Investors can now customize specific holdings according to their needs. They can diversify around concentrated positions they may have and create a portfolio that mimics the index. Opportunities for tax-loss harvesting also exist at the individual security level to offset capital gains and enhance after-tax returns. Let’s explore this in more detail below and discuss who’s a good fit for direct indexing, as well as some benefits and drawbacks.
Who is a Good Fit for Direct Indexing?
Investors that are looking to replicate the performance of an index, customize their positions, or those with large, concentrated holdings might find direct indexing a good option. Investors may want to implement preferences such as ESG into their portfolios or have increased exposure to certain sectors like technology or investing styles like value or momentum. Investors may also want to adjust their direct indexed portfolio to counterbalance a large outside stock position to increase diversification. (Ex. if they own low-cost basis company stock.)
Direct indexing uses numerical algorithms. It looks at stocks an investor already holds, some of which may be large positions at low-cost basis. It determines which other stocks in the index they’d need to purchase and in what quantities. From this, it would be able to mimic the movement & volatility of that index and reduce risk from the concentrated position.
In addition, clients with large unrealized gains within their portfolios are a good fit for direct indexing to lower their tax burden. Stocks in the direct indexing pool trading below their cost basis can be sold or “harvested” while the winners are kept. The proceeds are reinvested into stocks of companies similar to those dropped.
However, direct indexing isn’t for everyone. In fact, it’s not a good fit for most people. Direct indexing is of most benefit to those who have substantial taxable assets or have large concentrated, low-cost basis stock they’d like to diversify around. It’s also most advantageous to those in high-tax brackets. There is very little tax benefit to those who only own tax-deferred accounts or have tax-efficient investments in their taxable accounts. However, even if there are no tax benefits, direct indexing could make sense if an investor wants to overweight or exclude holdings in a particular security or sector.
A summary of the best situations for direct indexing is summarized below:
Tax Considerations
What are Benefits of Direct Indexing?
- Customization of Portfolio
Direct indexing allows you to customize an investors’ portfolio according to their personal preferences. One can tilt client portfolios toward stocks with certain features such as momentum or value or those stocks with ESG characteristics. Certain industries or sectors can be under-or-over weighted according to investors’ preferences. Screens can be implemented to exclude certain companies that don’t align with an investors’ values. Companies can also be excluded from a direct indexed portfolio in which the investor already has a concentrated position. This type of customization would be more difficult with standard investment options such as ETFs or mutual funds.
- Managing Large, Concentrated Positions of Stock
This is one of the most advantageous reasons to use direct indexing. Advisors can customize indexes for clients with significant, concentrated holdings of stock, thereby reducing their overexposure to a specific holding. For example, if a client is an employee of Google and owns company shares, just owning the S&P 500 exposes the client to concentration risk. With direct indexing, a portfolio can be generated without buying Google. Instead, the algorithm finds stocks to buy in other industries with similar return patterns to Google. This effectively replaces it and reduces risk.
In addition, a large position can be whittled down over time by offsetting gains from selling it with capital losses generated from other securities in the direct index portfolio.
- Tax Management
Since individual securities are purchased, it’s possible to tax-loss harvest each stock
to help manage the investor’s tax bill. Investors can control when and how to realize capital gains. An ETF or mutual fund doesn’t offer this ability to harvest individual positions. If, for example, one stock needs to be sold for a profit, a direct indexing strategy can offset that gain by selling a different stock at a loss, thereby generating tax alpha. Capital gains from outside investments can also be mitigated by using a direct indexing strategy.
- Charitable Giving
With a direct indexed portfolio, investors can implement charitable giving for causes they support while gaining tax efficiency. Highly appreciated stocks can be donated, offering a tax break while supporting worthwhile causes. This makes it a win-win situation for investors.
What are Drawbacks of Direct Indexing?
Some drawbacks of direct indexing include the possibility that your investment performance could deviate from the performance of the benchmark. This is called tracking error. If you choose to customize your portfolio toward certain factors or sectors or with ESG, this tracking error could occur. This may not be desirable if an investor wants to replicate the performance of an underlying index such as the S&P 500. There is the risk of underperforming the index you are trying to follow.
Another drawback is the fact that the tax benefits of direct indexing are really only available for those investors with substantial taxable assets to invest. The higher the federal and state tax bracket, the greater the potential benefit.
In addition, the larger the pool of money that is available for direct indexing in relation to the investors’ other investments, the better the chance to offset capital gains. Therefore, direct indexing isn’t as advantageous for the smaller investor.
Furthermore, constant replenishment/deposits into the investment pool for direct indexing is ideal to generate tax-loss harvesting opportunities. This may not be the case for investors that don’t have funds regularly flowing into their accounts.
Direct Indexing’s Perfect Storm
*Source: Press Release: Direct Indexing Growth Projected to Outpace ETFs, Mutual Funds, and Separate Accounts Over Next Five Years, According to Cerulli, Cerulli Associates, August 2021. https://www.cerulli.com/press-releases/direct-indexing-growth-projected-to-outpace-etfs-mutual-funds-and-separate-accounts-over-next-five-years-according-to-cerulli.
Next Steps:
- Determine if you might realize potential tax, diversification, or customization benefits through direct indexing.
- If direct indexing might make sense, analyze various indices to decide which one you might track, and which assets you would use to track that index.
- Take a deeper dive into your overall financial situation using our free EASI Retirement Calculator:
