Direct Indexing: A Modern Approach to Customized Investment Strategies
By: Sloan Smith, MBA, CAIA, CPWA® and Matthew Foster
Direct indexing is an investment strategy that typically replicates or tracks an equity index (i.e., S&P 500) while allowing for the customization of underlying securities within the portfolio. It combines the personalized approach of separately managed accounts, with investor control of the underlying positions, with the efficiency of index funds, resulting in a relatively low-cost investment product. Initially reserved for larger investors who had the resources to create and maintain a custom index fund managed by professionals, direct indexing has evolved to be more accessible to smaller and individual investors, leading to a significant increase in popularity.
In 2020, several specialized direct indexing firms were acquired by prominent asset managers, including Morgan Stanley, BlackRock, JPMorgan, Vanguard, and Franklin Templeton.[1] This consolidation contributed to substantial inflows into the industry, beginning around 2018.[2] The increased interest and investment in direct indexing reflects a broader trend towards personalized investment solutions, where underlying clients and institutions can tailor their specific preferences. Before implementing, however, it is important to understand the advantages and disadvantages of this strategy as part of an portfolio.
Advantages:
1. Tax Loss Harvesting
Managing capital gains is a crucial consideration for taxable investors, and direct indexing provides a valuable tool to minimize this issue. Consider a scenario with two investments: Investment A, with a $10,000 gain, and Investment B, with a $15,000 loss. Through tax-loss harvesting, selling both investments results in a net loss of $5,000. Under current Internal Revenue Service (IRS) regulations, you may deduct $3,000 of that loss to reduce your ordinary income, while carrying over the remaining $2,000 to offset future gains or further reduce ordinary income tax liability through loss carryforwards. Index exposure, tax-loss harvesting, and potential loss carryforwards are true benefits of this strategy.
2. Portfolio Customization
Direct indexing offers investors the ability to customize portfolios by screening or excluding certain companies, based on a wide range of criteria. If an investor prioritizes environmental sustainability and wishes to invest in companies that align with those values, for instance, the investment manager can screen out companies that inefficiently use natural resources or have significant carbon footprints. These custom screens can also be tailored to reflect religious beliefs, morals, values, or any other criteria they choose.
3. Low Cost
Direct indexing products are offered at reasonable fees. The typical range, on average, is from 0.16% to 0.25%[3], which is quite advantageous, particularly when compared to more active peers.
4. Diversifying Concentrated Stock Positions
Direct indexing provides a tax-efficient way to reduce positions in single stocks with large unrealized gains. By contributing a concentrated position to a direct index product, the strategy can ultimately realize losses through tax-loss harvesting. Realized losses can then be utilized to offset gains in the single stock and reduce the size of the position.
Disadvantages:
1. Potential for Higher Trading Costs
Direct indexing is not ideal if it tries to mimic an index where there is a high turnover of stocks. For example, a direct indexing strategy that tries to replicate an equal market-cap weighted index would be detrimental, due to constant rebalancing. Direct indexing works best with indices that have relatively stable compositions, where a limited amount of trading occurs.
2. Inability to Realize Losses Over the Long Term
Over time, if a portfolio of underlying securities within a direct indexing offering does not have any underlying losses, then the ability to tax loss harvest becomes almost negligible. Due to the strong performance of numerous indices (i.e., the S&P 500) this situation has become more prevalent. A taxable client may have to realize gains to rebalance the portfolio back to the index composition.
3. Lack of Differentiation
There are many large institutional firms that provide direct index strategies. However, many offerings are quite similar, and it is difficult to understand the differences in their methodology and philosophy. There is a concern that direct indexing is becoming a commoditized business, where fees play the most important role in determining which strategy is the most advantageous.
Direct indexing presents both advantages and challenges but stands out as a powerful tool for investors who seek the customization of separately managed accounts alongside the efficiency of index funds. These strategies enable seamless portfolio transitions by managing tax liabilities through tax loss harvesting while offering a personalized experience that surpasses that of typical index funds. Importantly, direct indexing allows investors to align their portfolios with their values and beliefs without compromising their market participation. The key decision for investors is whether the benefits of customization and tax loss harvesting outweigh the higher costs when compared to traditional index funds. Overall, the significant growth of direct indexing in recent years clearly demonstrates its many advantages and ensures its place in the future of investing.
[1] CFA Institute https://blogs.cfainstitute.org/investor/2021/11/08/the-mirage-of-direct-indexing/
[2] WSJ: What is Direct Indexing? https://www.wsj.com/buyside/personal-finance/investing/direct-indexing
[3] Savvy Wealth: The Benefits of Direct Indexing https://www.savvywealth.com/blog-posts/what-is-an-index-fund-and-is-it-reasonable-to-invest-in-the-benefits-of-direct-indexing
Figure 1 (Assets under Management inflows for Direct Indexing from 2015-2020)[1]
