Direct Indexing: Investing’s Latest “Trend”

I have never been known as someone who dresses very fashionably, but even I understand that certain fashion trends come and go…and come again. As one of the “newest” ideas in investing, direct indexing follows this same concept.

If we look back over the timeline of investment vehicles, it all starts with individual stocks. The first stock market began in Amsterdam in 1611, and the doors of the New York Stock Exchange were opened in 1903, although stocks were traded in the US long before that. Of course, in those days, stocks were traded in a slightly different manner and usually with an actual paper certificate.

In 1924 the first mutual fund was created, but this did not really catch on with investors until the 1980s. At the time, mutual funds were considered an innovative investment vehicle because they allowed investors to diversify their holdings without having to buy hundreds of individual stocks themselves. Each mutual fund had a manager who was buying and selling individual stocks inside the mutual fund. The idea was that the manager would hopefully outperform a benchmark, such as the S&P 500. One downside to the mutual fund was cost, which was–and remains–higher than owning an individual stock. In addition, historical data shows that mutual fund managers have never been very adept at outperforming their benchmark.

Fast forward to the early 2000s and exchange-traded funds (ETFs) were created and provided an alternative to the mutual fund. Like mutual funds, ETFs allow investors to diversify their holdings more easily than buying individual stocks, although ETFs usually have a much lower cost structure than mutual funds. In addition, investors began to question whether a mutual fund manager could regularly outperform an index, and thus, many did not want to pay a manager but still wanted to be diversified. ETFs do not have a fund manager but rather are created by a company to simply track an index, such as the S&P 500. If there is no fund manager to pay, costs can be much lower. Another advantage to ETFs over mutual funds is intra-day trading. Mutual funds get valued at the end of each day after the close of trading, so investors cannot sell during the middle of the day. ETFs on the other hand, fluctuate throughout the day like any other stock and can be sold at any point during the trading day. This creates flexibility for investors as far as liquidity and getting access to cash a bit quicker. ETFs are at the core of our Stewardship Advisors’ portfolios for the reasons outlined above. Yet, just like fashion, what was once popular may be making a comeback! Owning individual stocks is once again in vogue–though not quite in the same manner as in the 1600s!

As mentioned above, one of the reasons mutual funds–and now ETFs–became popular is because they allow investors an “easy” way to own hundreds of stocks. Instead of researching individual companies, you are simply evaluating the manager or selecting an index in which you wish to invest, not the hundreds of underlying stocks. But what if you could combine the simplicity of an ETF (no manager, just track an index) with individual stocks? Thanks to technology, you can now do just that, and it is called direct indexing. In very simple terms, direct indexing allows you to pick an index-(i.e. the S&P 500) and buy the stocks that make up that index directly.

Theoretically, direct indexing could have been done in the past. “All” you would have had to do was examine the index to see which stocks made up that index, determine their weighting in the index, and then buy the appropriate number of shares for each individual stock based upon the size of your portfolio (Hey, I did not say it was the most realistic investment strategy!) Like many things in our day-to-day life though, advances in technology allow us to deploy this strategy with our clients.

Benefits of Direct Indexing

There are several benefits to direct indexing, but I will highlight three that I think are the most important:

1. Customization – Direct indexing gives investors the ability to truly customize and tailor a portfolio to their investment preferences. We can provide investors with a long list of industries they may want to exclude from their portfolio. We can even get as granular as to exclude specific companies from your portfolio. For example, both Apple and Alphabet (who make Android phones) are in the S&P 500. However, I’m an Android person, so I could say I want my portfolio to mimic the S&P 500. My instructions might be “don’t buy Apple, replace it with a different technology company that is like Apple.”

2. Taxes – We often say that you do not want the tax tail to wag the dog. In other words, while a prudent tax strategy is important, it should still fit in with your overall investment plan. Direct indexing could help manage taxes through a strategy known as loss harvesting, which includes purposely selling stocks at a loss to offset current or future year investment gains. While the benefits of loss harvesting will vary for each individual investor depending on income and capital gains tax bracket, it is yet another tool we can use to maximize your overall wealth.

3. Cost – As outlined above, direct indexing allows you to buy individual stocks, so you are not paying a mutual fund manager or even an index manager. Thus your overall portfolio costs should be lower.

Things to Consider

While direct indexing certainly has its advantages, it is not perfect. No investment is. Below are a few things to keep in mind:

1. Paperwork (or email) – You know those nice thick books you either receive in the mail or find in your inbox? They are called prospectuses, and every security (investment) must issue one. This means if you own several hundred stocks, you will get several hundred prospectuses. It also means you would get several hundred proxies, which are the voting ballots you receive every year. If you are an investor who likes to do things with paper, you may have to “up” your Christmas gift to your mailman if you start using direct indexing. We highly recommend paperless if you are going to pursue direct indexing, but even then, be aware you will get a lot of emails.

2. International Stocks – From our experience, direct indexing does not work well for international stocks. They trade on other exchanges, so trading would have to be done at all hours of the day, when the London stock exchange or Asian stock exchange is open for example.

3. Bonds – Similarly for bonds, it would require purchasing individual bonds issued by different companies, which again, is not very realistic on a large scale. For both international stock and bond portions of a portfolio, we have found that utilizing ETFs is still (usually) the best option for investors.

Just like tie-dye and crop tops, direct indexing is not for everyone. While some things probably should never make a fashion comeback, owning individual stocks through direct indexing is another tool at our disposal to help our clients manage and grow their wealth. If you would like to explore whether direct indexing makes sense for your situation, please do not hesitate to reach out to our firm or your advisor.

Schedule an introductory phone call with Mark at this link: Mark Brinser – Introductory Phone Call

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