What every investor should know about direct indexing

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What every investor should know about direct indexing

Interest in “direct” or “personalized indexing” is growing because it combines the lower cost of passive investing with the possibility for customization. Improved tax efficiency adds to the appeal.

Here are answers to common questions about this more flexible way to invest.

How does direct indexing work?

Investors who own mutual funds or exchange-traded funds (ETFs) own stocks indirectly. That is, they own shares in the fund, which, in turn, owns the securities. With direct indexing, an investor owns the stocks in the index, without a fund as an intermediary.

Why now?

Long available only to ultra-high-net-worth individuals, direct indexing is becoming increasingly available to everyday retail investors. In the past, high commission fees and the inability to buy fractional shares limited direct indexing to the wealthy. With zero commissions now common, the cost of direct indexing has come down, and the ability to buy fractional shares has made it feasible for smaller portfolios.

Morningstar describes direct indexing as an updated version of separately managed accounts (SMAs), which provide personalized management to wealthy investors. But while SMAs generally require a minimum investment of as much as $250,000, new direct indexing services typically require much less. Schwab and Fidelity, for example, require only $100,000 and $5,000, respectively.

How can I customize my investments?

Direct indexing allows investors to control their portfolio in three ways:

1. Index selection. The investor may choose from a variety of indexes. While many will choose a broad market index, such as the S&P 500 or the Wilshire 5000, others might start with one that is more focused.

2. Security selection. Investors can customize their holdings―something they can’t do with a fund. For example, investors might want to avoid overconcentration in a particular sector. Or they might object to tobacco or alcohol stocks or want to “tilt” their exposures toward growth or value.

3. Tax-loss harvesting. By owning individual stocks, investors are able to decide which securities to sell and when, offering them more control over the tax impact of their gains. For example, they can sell stocks that lost money to offset gains generated by the winners, thereby reducing or even eliminating their capital gains tax bill.

What about fees?

Because direct indexing is not purely passive, fees are generally higher than what index funds charge. Nevertheless, they still are lower than a typical actively managed fund.

As of late 2021, Morgan Stanley estimated the average direct indexing fee at 0.30% of assets.1 In contrast, the average fee was 0.47% on an actively managed equity fund and 0.16% on a stock ETF.

Direct indexing vs. other passive and active strategies

1. Implementation strategy - Objective

ETF, index-tracking - Index replication

ETF, factor investing - Factor tilts

Direct indexing, SMAs - Factor or ESG tilts; tax-loss harvesting

Active, SMAs - Security selections; factor tilts; (potential) tax-loss harvesting

Active, commingled - Security selection; factor tilts

2. Implementation strategy - Expense ratio

ETF, index-tracking - Lowest

ETF, factor investing - Low

Direct indexing, SMAs - Lowest to low

Active, SMAs - Low

Active, commingled - Highest

3. Implementation strategy - Allowable customization

ETF, index-tracking - None

ETF, factor investing - Beyond initial exposure selection, none

Direct indexing, SMAs - Yes, including factor or ESG tilts, sensitivity to existing holdings

Active, SMAs - Beyond initial exposure selection, typically limited to negative screening

Active, commingled - Beyond initial exposure selection, none

4. Implementation strategy - Tax-loss harvesting

ETF, index-tracking - Limited to entity level

ETF, factor investing - Limited to entity level

Direct indexing, SMAs - Yes, effective to the single-security level

Active, SMAs - Yes, but more limited than direct indexing

Active, commingled - Limited to entity level

5. Implementation strategy - Tracking error

ETF, index-tracking - Lowest

ETF, factor investing - Medium

Direct indexing, SMAs - Low

Active, SMAs - Highest

Active, commingled - Highest

Source: Morgan Stanley Wealth Management Portfolio Analytics.

Are there any drawbacks?

Liquidity. The ease of buying or selling an asset such as shares of stock is known as “liquidity.” Some stocks are widely owned and therefore are easy to buy or sell — they’re highly liquid. Others are less so. Less liquidity can mean that investors might pay a higher cost when purchasing stock and receive a lower price when selling it.

Potential Underperformance. The point of passive investing is to roughly match the performance of a chosen index. Failure to match the index is known as “tracking error.” Since direct indexing involves diverging from the index’s holdings to some degree, it’s not purely passive. So, tracking error might be higher than on a purely passive fund. In other words, your personalized portfolio might outperform the index, but it might also underperform.

Complexity. Direct indexing can also be more complex. Because it involves owning many securities, it makes an investor’s account statements more complicated. Tax preparation can also be more challenging.

Can I do direct indexing on my own?

Stock market indexes typically are made up of hundreds of stocks. Purchasing and managing even a small but representative subset of these — say, 100 — would be difficult for most investors. Even a full-time professional investor would be challenged by a portfolio of this size. Amateurs with only their spare time available would likely find it unmanageable.

Where is direct indexing available?

Direct indexing via customizable managed portfolios is now available at major investment firms, including Fidelity, Vanguard and Schwab.


© August 2022, Future US LLC

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