Direct indexing – What are direct indexing strategies and how can they benefit investors?

Direct Indexing

Direct indexing – What are direct indexing strategies and how can they benefit investors?

Leverage the full potential of direct indexing

Direct indexing is a trend that has been growing steadily in popularity and accessibility in recent years, thanks to advances in cost structures, technology, and increasing consumer demand. Despite this rise, many investors today remain confused by the approach, what it could mean to them, the actual implications, and the ultimate benefits. So, in this spirit, let’s examine what it’s all about.

Direct indexing allows investors to hold the same stocks found in an exchange-traded fund (ETF) while offering them the ability to replace individual items. While direct indexing was once reserved solely for ultra high and high net worth (HNW) investors, and institutions (i.e. anyone that was able to meet very high investment minimums), it is now available to a much wider range of investors.

This has served to multiply the tools available to financial advisors and portfolio managers to improve customization by the creation of tailored rules-based strategies. It also provides more efficient tax-loss harvesting solutions and serves as an opportunity to attract and engage with prospective and existing clients.

What is direct indexing?

In a nutshell, direct indexing involves the buying of individual component stocks within an index, which results in an investor owning the holdings of an index (or owning a representative subset of an index). This is in sharp contrast to mingled funds and ETFs that sit in between investors and the stocks they own.

Direct indexing was first developed in the 1990s as a tax efficiency tool. It mitigates tax losses by trying to replicate the pre-tax performance of well-established indexes while customizing an index to reflect each client’s unique needs, risk, and personal values preferences.

The ultimate goal has always been to allow investors to tailor an index to meet their specific circumstances and optimize for things like taxes, ESG exposure, and factor exposure.

What makes direct indexing different?

Mutual funds and ETFs do not allow individual investors to customize their portfolios by adding and removing various stocks or assets. A direct indexing strategy differentiates itself from the other options by offering greater autonomy, control, and tax advantages to certain investors over owning an index mutual fund or an index exchange-traded fund.

What are the advantages of this type of investing?

Direct indexing strategies serve as an attractive alternative to certain index mutual funds or index exchange-traded funds (index ETFs) for investors who want more choice, greater autonomy, flexibility, and are hoping to mitigate tax losses while harvesting capital gains.

Direct indexing also provides financial advantages to investors wishing to make charitable donations by allowing them to donate shares within an index that have the largest gains while improving their after-tax outcomes.

Greater flexibility for investors

Despite the variety of mutual funds targeting different factors, such as sectors and geographic regions, it is difficult for investors to reflect their preferred allocation without a combination of funds. Direct indexing offers a solution to this issue thanks to its customization capabilities. This type of portfolio can be modified by the investor in order to build a portfolio according to sought-after characteristics, such as value or momentum.

Most stocks are not likely to outperform the market index, so whether an ETF is in an up or down year, some of its underlying stocks may still be performing poorly. ETF holders can’t pick off losing securities and replace them with better performing options, they would have to sell off the whole investment.

Unlike investors using an Exchange Traded Fund (ETF), direct indexing allows for removing or adding individual stocks.

Improved Tax Efficiency

Most people wouldn’t think of losing money as a good thing, however direct indexing investors can use the stock market’s bad news to reduce their taxes. Working with a financial advisor also allows a client to use his capital losses to offset other gains.

Because an SMA contains individual securities and the investor directly owns each position, an investor can qualify for losses on stocks or bonds that have performed poorly. This strategy known as tax-loss harvesting can help boost the investor’s after-tax returns. The way to harvest losses is through contributions to a tax-exempt charity.

Customization: Concentrate or Diversify your Portfolio

Diversification is a key feature of building successful portfolios. While most clients build the entirety of their portfolio to meet the full scope of their desired diversification, this isn’t always the case. For instance, investors that have received a sizable gift, an employee compensation, or who owns an especially successful stock may not want to face the tax implications associated with their capital gains.

In such situations, direct indexing may be an especially attractive solution. Indeed, one of the most impressive innovations offered by direct indexing is the ability to transcend the “one-size-fits-all” approach to diversification, by customizing indexes, based on an investor’s circumstances and preferences.

Direct indexing thus allows money managers to work with clients with a range of needs. That includes those with a single concentrated area to invest around, as well as those who need to avoid entire sectors for any number of reasons.

Rules-based advisor investment strategies

Direct indexing offers financial planners the possibility to define and create their own rules-based investment strategies – on a client-by-client basis – at the stock level, rather than having to rely on rigid rules applied to prepackaged funds and ETFs.

This further adds to the customization potential of direct indexing, by allowing wealth managers to tailor the investment rules of a given portfolio according to the risk/return profile, geography, industry, ESG preference, or any other factors. Ultimately, direct indexing platforms enable advisors to create their own personalized Smart-Beta investment strategies.

Customized completion portfolios

Completion portfolios are crucial to diversify existing concentrated holdings and align the overall portfolio to the benchmark. Thus, direct indexing enables advisors to take a defensive approach by reducing risk exposures without realizing significant gains to diversify.

Is direct indexing right for you?

Direct indexing is a relatively new option for the vast majority of investors in today’s market for a simple reason: It was extremely expensive. In order to reproduce the performances of an index such as the S&P 500, an investor would have had to buy each individual stock, with each transaction having associated fees and commissions. In recent years, the amount of zero-commission trading on several brokerage platforms has removed this barrier of entry.

However, direct indexing is still a complicated investing strategy that requires extensive financial knowledge. Even more, the simple act of buying hundreds of stocks and rebalancing your portfolio is time consuming.

What is tax-loss harvesting?

A way of improving your required rate of return or decreasing taxes due on your income is tax loss harvesting. This strategy involves selling an investment that has lost value and replacing it with a more favourable investment. You then use the capital losses to offset gains more quickly or decrease your tax burden. This process can also improve your portfolio’s overall performance.

Direct indexing and ESG

Direct indexing is a method of autonomous investing that allows investors to choose and reject individual companies. This is perfect for environmentally friendly or ESG oriented investors looking to avoid specific types of businesses.

By taking an index such as the S&P 500, the Dow Jones Industrial Average (DJIA) and adjusting it by removing companies you do not support, it is possible for an investor to replicate the index’s performances without compromising his or her values and beliefs.

By purchasing a stock directly from the company, an investor’s interests are protected against the firm. Shareholders are able not only to warn the company about environmental degradation, but also to immediately unload their shares. This would not have been possible for individuals investing in an ETF or a mutual fund.

What is the difference between mutual funds, ETFs, and direct investing?

What is a mutual fund?

A mutual fund is created from money pooled from multiple investors and used to invest in any assets, including stocks, bonds, and various money market instruments. Each investor has a claim to the capital gains proportionate to his position in the fund. Mutual funds are appealing since they give small investors an affordable access to professionally managed portfolios.
Mutual funds are operated on the investor’s behalf by professional investors following an investment strategy, meaning the individual investor cannot make any changes to the fund’s selected assets. However, a client benefits from professional management.

What is an ETF?

An exchange-traded fund (ETF) is a basket of securities that usually tracks a particular index, such as the S&P 500, a sector, or a specific type of asset. Similarly to stocks, they can be traded directly on the stock market.


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