Move to ETFs: direct indexing is an investment strategy worth paying attention to

Recently, direct indexing, a lesser-known investment approach, has begun to overtake ETFs and mutual funds in investor adoption. Direct indexing offers unique benefits that cannot be replicated in a traditional ETF or mutual fund structure, particularly with respect to customization and tax management.

Given its benefits, direct indexing is expected to continue to outpace the growth of ETFs and mutual funds over the next few years according to a recent Cerulli report. Here’s what you need to know about this growing method of investing.

What is Direct Indexing?

Direct indexing is an investment strategy in which an investor directly holds individual stocks that make up an index in their own account, 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. However, when an investor holds the individual securities directly in their account, it allows for greater customization and the potential for greater tax benefits.

Direct indexing has been central to the strategies of many wealthy clients for decades. This is not a surprise, given its unique advantages, especially in terms of taxation. Offered primarily through financial advisors, minimum investments for direct indexing are often $250,000 or more. However, commission-free trading and fractional shares have made the strategy more widely accessible, with minimums at or below $5,000 in some cases.

A lower tax bill

With hundreds of individual stocks held in a direct-indexed portfolio, there are plenty of opportunities to reap tax losses – the practice of selling a security at a loss to offset capital gains. Even in bull markets, individual stocks can experience episodes of poor performance. Direct-indexed portfolios can take full advantage of this, reaping losses from underperforming stocks even as the market as a whole rises. That can mean 1% or more in extra after-tax returns, according to recent avant-garde research.

A separate study looked at historical returns over the past century and found that direct indexing added 1.08% per year to 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 initial investment of $100,000 grow to around $630,000 after taking into account taxes. That’s $101,000 more than they would have otherwise.

Note: The dark blue line in the chart represents the after-tax value of a portfolio that tracks the S&P 500 using direct indexing and employs a tax-loss collection strategy. In 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 portfolios to be built around existing holdings. This becomes especially important when a portfolio has priced in concentrated positions. In such a case, an investor can diversify their existing positions while managing the potential tax impact of liquidating positions.

Fine tunning

By holding securities in their own accounts, investors are free to customize portfolios as they see fit. Such personalization is not possible in a fund because each investor is exposed to the same set of underlying securities as all other shareholders.

Direct-indexed portfolios can lean toward ESG factors or exclude securities that don’t align with an investor’s values. Since this can be done at the individual account level, investors do not need to compromise on their values ​​when building their portfolio. Additionally, owning individual shares allows shareholders to participate directly in proxy voting, another source of control for investors.

Personalization offers another important benefit: better behavior. It’s often easier not to overreact in a bear market and stick to a savings plan when your investments reflect your values.

However, excessive customization can lead to a deviation – positive or negative – of the performance of the direct index compared to the target index. Each investor has their own risk and performance tolerance, and investors should be aware that there is a trade-off between customization and benchmark tracking.

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 more useful when an investor has capital gains to offset other investments. For investors with little or no external capital gains, the tax benefits granted are more limited.

Additionally, direct indexing has more moving parts than a wallet that uses funds. Holding individual securities and trading them to reap tax losses means more transactions to book 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 advantages that are difficult or even impossible to reproduce with a fund. Recent innovations, such as fractional stock trading, have lowered the barrier to entry into direct-indexed portfolios.

A once rarefied investment strategy is now ripe for wider adoption and with it the potential to generate better results for many investors.

Head of Investments, Altruist

Adam Grealish is Head of Investments at Altruistic, a fintech company whose mission is to make quality independent financial advice more affordable and accessible. With a career rooted in financial innovation, Adam most recently led strategic asset allocation, fund selection, automated portfolio management and tax strategies at Betterment. Additionally, he served as a Vice President at Goldman Sachs, overseeing structured corporate credit and macro credit trading strategies.

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