Is direct indexing a better investment strategy than ETFs?

Private investors have come to love exchange-traded funds (ETFs), which allow them to easily track multiple global markets and maximize their returns while paying incredibly low annual fees.

It was a welcome revolution that empowered small investors and saved them from handing over small fortunes under fees to expensive active fund managers.

Yet ETFs have one major drawback. While they are almost guaranteed to match the performance of their chosen index, minus that small fee, they will never beat it.

This is because they are required to buy every stock included in the index, the good, the bad and in some cases the downright ugly, and passively follow them up or down.

Now, the ETF twist offers investors the chance to filter out the bad and the ugly from their portfolio and buy only the good.

It’s called direct indexing, or sometimes custom indexing, and it helps investors or their advisors build a customized portfolio that offers more freedom and flexibility than ETFs or actively managed mutual funds.

The concept has taken the US market by storm, where it is expected to grow faster than any other investment vehicle over the next four years.

Cerulli Associates expects growth in direct indexing to outpace both ETFs and active funds, with an average annual growth rate of 12.3 percent per year.

Assets invested in direct indexing will nearly double to about $825 billion by 2026 from $462 billion last year, according to a report sponsored by direct indexing provider Parametric Portfolio Associates.

Cerulli research director Tom O’Shay believes direct indexing is poised to deliver “mass personalisation” and provide a “silver bullet” for investors, but what does the concept mean in practice?

First, if you haven’t heard of direct indexing, don’t worry. The concept is relatively new and mostly limited to the US, but that’s what ETFs were in the beginning, and look how quickly they’ve taken the world by storm.

The main difference with direct indexing is that you buy individual stocks in the market, not all of them, as you would with an ETF or mutual fund.

Besides the cherry-picking benefits, this allows you to copy the performance of this index by directly buying several of its constituents and adjusting them over time, says Vijay Valecha, chief investment officer at Century Financial.

Because you own the individual stocks, you can adjust your holdings to suit your specific circumstances.

“Unlike universal ETFs or mutual funds, you can customize your portfolio to, say, more tech stocks and less utility stocks,” he says.

If an investor already has a large stake in an individual company included in an index they want to track, direct indexing allows them to exclude that company from their portfolio.

For example, someone who made a big bet on electric car maker Tesla might be reluctant to double down by also buying into a tracking technology tool.

The same may be true if an investor already owns a bunch of shares in his employer and does not want further exposure by buying the index in which he is included.

Direct indexing also allows investors to exclude a stock or sector on environmental, social and governance (ESG) grounds, say if they don’t want to buy a tobacco producer or fossil fuel exporter.

This seems to offer the best of both worlds, at least in theory. Passive investing, with active engagement.

Unlike universal ETFs or mutual funds, you can customize your portfolio to, say, include more tech stocks and fewer utility stocks

Vijay Valecha, Chief Investment Officer, Century Financial

Mr. Vallecha says it has an added benefit because it can offer tax advantages that traditional ETFs don’t, known as tax-loss harvesting.

“This involves selling individual securities in your portfolio at a loss, even when the index has risen overall,” he adds.

By doing this, you can generate losses to offset against your capital gains from other positions in the same tax year, potentially reducing your overall bill.

“Over time, these additional tax savings can add up significantly,” he says.

Vanguard’s custom indexing automatically scans investors’ portfolios daily for tax-loss harvesting and rebalancing opportunities, helping them optimize holding periods and offset capital gains and losses.

That strategy isn’t an option when investing in standard ETFs because you only own units in the fund, but rather the individual securities, Mr. Valecha adds.

One disadvantage is that it takes time and effort to identify and purchase the securities.

“Some of the shares may not be readily available to buy, making it difficult for smaller investors to get them at a reasonable price,” says Mr Vallecha.

Until recently, only large institutional clients or high-net-worth investors could benefit from direct indexing, but now platforms such as Fidelity, Schwab, BlackRock, Vanguard and Morgan Stanley are opening the concept to a much wider market by offering cheaper, automated services .

How much you need to access the service varies. For example, Fidelity offers it from $5,000, while Schwab’s minimum investment is $100,000.

Jason Hollands, managing director of fund platform Bestinvest at Evelyn Partners in the UK, says the perceived tax advantages of direct investing will depend on the country.

“In the UK, for example, mutual fund structures are very tax efficient as intra-fund transactions do not result in capital gains tax liabilities. You only crystallize a profit when you sell shares in the fund itself, so there’s no real benefit here.”

Giles Coghlan, chief market analyst, advisory, for brokerage HYCM, suggests that the possibility of individual stock exclusions may be overstated.

“Even if a stock falls deeply, if it’s part of a larger index like the S&P 500, it’s not particularly harmful to your portfolio.”

David Morrison, senior market analyst at Trade Nation, says this remains a niche and for most investors ETFs remain the simplest and cheapest option.

“Direct indexing takes time and effort, both from you and your financial advisor. This means there will be management fees and commissions if you actively buy and sell individual stocks within the index.”

These can be offset through tax savings, but the process will work best with larger portfolios that offer economies of scale.

“In contrast, it’s relatively cheap to buy and hold an ETF, even though you have no control over what’s in it,” Mr Morrison says.

For most investors, ETFs will be sufficient. Having more control is great, unless it comes at the cost of even more complexity.

Updated: January 31, 2023, 5:00 a.m

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