An Investment Strategist Demystifies Direct Indexing: Is It for You?
You've heard of mutual funds and ETFs, but direct indexing may be a new concept ... one that could offer greater flexibility and possible tax savings.
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Client demand for personalized investment strategies continues to increase, and direct indexing has become one of the fastest-growing segments in the managed account space.
Direct indexing is the leading category for manager-traded SMAs, with direct indexing assets closing 2024 at $864.3 billion, according to Cerulli Associates.
Direct indexing provides an alternative to index mutual funds and passive ETFs for investors who want more choice, greater flexibility and the potential tax advantages that those commingled investments simply can't offer.
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The Kiplinger Building Wealth program handpicks financial advisers and business owners from around the world to share retirement, estate planning and tax strategies to preserve and grow your wealth. These experts, who never pay for inclusion on the site, include professional wealth managers, fiduciary financial planners, CPAs and lawyers. Most of them have certifications including CFP®, ChFC®, IAR, AIF®, CDFA® and more, and their stellar records can be checked through the SEC or FINRA.
What is direct indexing?
Most of us are familiar with mutual funds and passive exchange-traded funds (ETFs), which package underlying securities into a single vehicle accessible to investors.
Anyone who purchases shares in a passive index-tracking ETF can gain broad market exposure to the benchmark of their choice — for example, the S&P 500, the Russell 3000 and so on.
Direct indexing takes this idea in a different direction. Instead of owning shares in a commingled fund, the investor owns the individual securities in the portfolio directly, in a separately managed account (SMA).
The investor gets the same kind of broad market exposure but with compelling advantages, including the potential to improve after-tax outcomes.
For example, unlike an ETF, direct indexing allows investors to customize their portfolios to actively harvest capital losses from individual securities.
What are some advantages of customization?
Different investors have different priorities, and direct indexing may not be ideal for all investors. Is the client willing to invest in more complex products? What has their previous investment experience been like?
Understanding the investor's perspective can help advisers build the right portfolio for them.
Direct indexing allows investors to personalize their portfolios based on their priorities and may help them to:
- Identify and seek to take advantage of tax efficiencies
- Avoid overconcentration in a particular stock or sector by avoiding redundant or risk-compounding portfolio holdings
- Adjust allocations to overweight or underweight certain market sectors
- Combine multiple benchmarks to achieve their desired exposure
- Screen out certain industries or companies that don't align with their values
Direct indexing's direct ownership of individual securities offers powerful flexibility around charitable giving and estate planning. And direct indexing isn't limited to equities. You can build a direct indexing custom SMA using fixed income, too.
Is direct indexing right for all investors?
Direct indexing's benefits can vary depending on an investor's profile, but the types of investors who may see the greatest value from it include those who:
- Are in a higher tax bracket, so they may have more taxes to save
- Have a long-term investment focus, so they may reap more benefits from tax deferral
- Express convictions about responsible investing, so they may appreciate values-related customization
- Fund a portfolio with existing securities, so they may see real tax savings over selling all positions and reinvesting in a commingled fund
Those whose profiles don't align with one or more of these traits might not see as many benefits to direct indexing — especially after taking costs into account.
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Compared with commingled vehicles such as ETFs, custom passive SMAs have higher fees and more operational complexity.
And because direct indexing involves customizing the broad market allocation, performance can deviate from the investor's chosen benchmark returns — often referred to as tracking error.
Many important roles in investing
Investors seeking to take advantage of direct indexing's benefits must be willing to tolerate some carefully managed tracking error.
For these reasons, many investors who don't naturally benefit from customization may continue to get market exposure through mutual funds and passive ETFs.
But we would stress that funds, passive ETFs, direct indexing and even active management aren't mutually exclusive: All have important roles to play in the investment ecosystem.
Direct indexing continues to grow in popularity and expand its range of use cases.
More and more investors are beginning to see the potential benefits of direct indexing, which can be a powerful tool to help them take greater control of their broad market holdings, while realizing more after-tax value from them.
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