Definition, Strategies, How to Invest

  • Direct indexing enables investors to individually own the underlying securities that make up an index.
  • Investors can customize their strategy, such as to save on taxes, rather than track the index exactly.
  • Direct indexing fees and account minimums can be much higher than investing in index funds.

When investors want to gain exposure to broad market segments, they often turn to index investing. By investing in a S&P 500

index fund

for example, an investor can essentially spread their money out across 500 large US stocks.

Among the most popular way to do so is through mutual funds or exchange-traded funds (ETFs) that track indexes by trading their underlying securities. Some investors, however, gain exposure via direct indexing, where they directly own the underlying assets that an index is based on, rather than using an index fund.

What is direct indexing?

Direct indexing provides a way for investors to have more control over index investing. To do so, an investor typically opens what’s known as a separately managed account (SMA), where they would then own the underlying assets of an index.

For example, if you wanted to engage in direct indexing that tracks the S&P 500, you would buy stocks like Amazon, Apple, and Microsoft that make up the index and then hold them in your SMA. However, you don’t have to follow the index exactly.

Perhaps you want to gain exposure to most of the S&P 500 but exclude a few companies that don’t align with your environmental or social values. In that case, you could simply avoid them and buy shares of the remaining companies within the S&P 500.

By owning the underlying assets directly, you can also trade them according to your own needs, rather than following what a mutual fund or ETF does. For example, many people who do direct indexing engage in what’s known as tax-loss harvesting. That involves selling assets that are losing money in order to get a tax deduction.

One way this might work is if an investor were to sell one laggard within an index and replace it with a similar stock (though certain rules apply to maintain eligibility for tax deductions). Then, a few months later after writing off the loss, they could repurchase the poor performer, hoping to profit from a rebound in its price. While they’re maintaining investments that closely reflect the index, they can make tweaks as needed.

“It’s about unlocking the power of customization,” says Mitchell Martin, founder and chief executive officer at Stonebridge Investment Counsel.

What are the advantages of direct indexing?

One of the top advantages of direct indexing is the ability to manage assets in a more tax-efficient manner, namely through tax-loss harvesting, as well as optimizing charitable giving.

Adding as much as 2% annually in tax alpha — which is the value added to the portfolio through tax strategies — can go a long way toward helping investors achieve their goals faster, says Martin.

Another big advantage is being able to customize holdings based on the companies you do or don’t want to support. For example, someone who is averse to firearms could exclude companies involved in that area, even if they’re part of an index they want to invest in, explains Martin.

Some investors also might have strong convictions about how certain companies will perform and will want to adjust their holdings accordingly, rather than following the index exactly.

What are the drawbacks of direct indexing?

Direct indexing’s main drawback is higher fees. Because of the level of customization involved, building a direct-indexed portfolio generally costs much more than buying index funds.

Charles Schwab, for example, has annual fees of 0.4% on the first $2 million in assets and 0.35% on more than $2 million. That compares with index funds that often only charge a few basis points per year. Some index funds even have zero expense ratios.

Similarly, the minimums required to open an SMA tend to be $100,000 or more. Many investors do not have access to that much money to engage in direct indexing, though over time direct indexing could become more accessible. Some firms like Fidelity offer more limited versions of direct indexing for much lower account minimums ($5,000 in Fidelity’s case).

Direct indexing can also create what’s known as a tracking error, which is when the performance deviates from the index. So there’s a risk that direct indexing returns might not be as high as those from an index-based ETF, for example.

Here’s a summary of the main pros and cons of direct indexing:

Is direct indexing right for you?

Because direct indexing typically involves higher fees and higher account minimums, it’s not always the best choice for investors. High-


individuals tend to use it the most, particularly those in higher tax brackets who benefit more from tax-loss harvesting. Plus, those tax benefits mean that direct indexing often makes more sense within taxable accounts, as opposed to, say, within a 401(k)Martin explains.

If you can meet the account minimums, then you want to weigh whether the higher fees of direct indexing are worth it for you to access the benefits.

“Clients have different sensitivities with regard to fees,” says Martin. “I think about the idea that we can generate somewhere between 1%-2% annually in terms of tax alpha, as contrasted to 30 basis points (0.30%) in terms of the costs of direct indexing. When I look at it, I see a positive spread.”

How to get involved in direct indexing

To get involved with direct indexing, individuals often turn to their financial advisors or brokerages. Brands like Natixis and Parametric are two well-known providers of direct-indexing services. Investors often access their platforms through their own advisors or brokers. Other firms such as Schwab also offer direct indexing.

In theory, you could also build your own direct index in a regular brokerage account by buying and selling securities that align with the underlying index you’re trying to track. However, that requires substantially more work and is probably beyond the average investor’s capabilities.

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