Recently, direct indexing, a lesser-known investment approach, has started outpacing both ETFs and mutual funds in investor adoption. Direct indexing offers unique benefits that can’t be replicated in a traditional ETF or mutual fund structure, particularly around personalization and tax management.
Given its benefits, direct indexing is expected to continue to outpace ETF and mutual fund growth over the coming years according to a recent Cerulli report. Here’s what you need to know about this growing investment method.
What is direct indexing?
Direct indexing is an investment strategy where an investor holds individual stocks that make up an index in their own account directly, instead of using a mutual fund or ETF to track the underlying index. Similar to an index fund, the goal is to track the performance of a target benchmark index. However, when an investor holds the individual securities directly in their account, it allows for more personalization and the potential for greater tax benefits.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Direct indexing has been the core of many high-net-worth clients’ strategies for decades. It’s no surprise, given its unique benefits, particularly around taxes. Offered mostly through financial advisers, investment minimums for direct indexing are often $250,000 or more. However, no-commission trading and fractional shares have made the strategy more broadly accessible, with minimums at or below $5,000 in some cases.
A lower tax bill
With hundreds of individual stocks held in a direct indexing portfolio, there are extensive opportunities for tax loss harvesting – the practice of selling a security at a loss to offset capital gains. Even in up markets, individual stocks can have bouts of poor performance. Direct indexing portfolios can take full advantage, harvesting losses in underperforming stocks even as the market as a whole is up. This can mean 1% or more in additional after-tax returns, according to recent research from Vanguard.
A separate study looked at historical returns over the last century and found that direct indexing added 1.08% annually in after-tax returns. From 1995 to 2018, the most recent period studied, an investor using a direct indexing strategy to track the S&P 500 would have seen their $100,000 initial investment grow to about $630,000 after accounting for taxes. That’s $101,000 more than they otherwise would have had.
Note: The dark blue line in the graph represents the after-tax value of a portfolio that tracks the S&P 500 using direct indexing and employs a tax loss harvesting strategy. By comparison, the light blue line represents the after-tax value of an ETF that tracks the S&P 500.
Sources: Chaudhuri, Burnham, Lo 2020; author’s calculations.
The flexibility of direct indexing also allows for portfolios to be built around existing holdings. This becomes particularly important when a portfolio has embedded gains in concentrated positions. In such a case, an investor can diversify around existing positions while managing any potential tax impact from liquidating positions.
Pinpoint personalization
By holding securities in their own accounts, investors are free to customize portfolios as they see fit. Such customization is not possible in a fund, as each investor has exposure to the same set underlying securities as every other shareholder.
Direct indexing portfolios can tilt toward ESG factors, or exclude securities that do not align with an investor’s values. Because this can be done at the individual account level, investors don’t need to compromise on their values when building their portfolio. Additionally, holding individual stocks allows shareholders to participate directly in proxy voting, another source of control for investors.
Personalization affords another important benefit: better behavior. It’s often easier to not overreact in a down market and stick to a savings plan when your investments reflect your values.
Too much personalization, however, can cause direct index performance to deviate – positively or negatively – from the target index. Every investor has their own tolerance for risk and performance, and investors should be aware that there is a tradeoff between customization and tracking the benchmark index.
Is direct indexing right for me?
One of the main advantages of direct indexing is that it can generate additional capital losses. Capital losses are most useful when an investor has capital gains to offset from other investments. For investors with little or no outside capital gains, the tax benefits afforded are more limited.
Additionally, direct indexing has more moving parts than a portfolio that uses funds. Holding individual securities and trading them for tax loss harvesting means more transactions to account for at tax time.
For many, direct indexing will be the future of investing
Direct indexing strategies are growing faster than other investment vehicles. And for good reason, the strategy offers benefits that are difficult or impossible to replicate using a fund. Recent innovations, like fractional share trading, have lowered the barrier to entry to direct indexing portfolios.
A once rarified investment strategy is now poised for broader adoption and with it the potential to generate better outcomes for many investors.
-
Time to Spring-Clean Your Finances: A Financial Professional's Four Steps to Tidy Them UpA midyear review of everything from spending to saving, with adjustments as needed, can set you on track to financial security. Plus, don't forget to check in on your workplace benefits.
-
Why a Law Firm Secretly Recording Client Conversations Is Wrong (and Illegal)A law firm that has been recording client conversations without the clients' knowledge or permission and has threatened employees if they speak out faces legal and ethical challenges.
-
Stock Market Today: Markets Discount Another U.S. DowngradeAfter Friday's closing bell, Moody's followed Standard & Poor's and Fitch and cut its rating on U.S. government debt.
-
Donating Complex Assets Doesn't Have to Be ComplicatedIf you're looking to donate less-conventional assets but don't know where to start, this charity executive has answers, such as considering a donor-advised fund (DAF) for its tax benefits and ease of use.
-
Think a Repeal of the Estate Tax Wouldn't Affect You? WrongThe wording of any law that repeals or otherwise changes the federal estate tax could have an impact on all of us. Here's what you need to know, courtesy of an estate planning and tax attorney.
-
In Your 50s? We Need to Talk About Long-Term CareMany people don't like thinking about long-term care, but most people will need it. This financial professional recommends planning for these costs as early as possible to avoid stress later.
-
Social Security Pop Quiz: Are You Among the 89% of Americans Who'd Fail?Shockingly few people have any clue what their Social Security benefits could be. This financial adviser notes it's essential to understand that info and when it might be best to access your benefits.
-
Stock Market Today: Investors Look on the Bright SideA generally good week closes on another positive note, as investors, traders and speculators look for fresh catalysts.
