Ever wish you could make changes to the index fund in which you invest? While in the past this may have been reserved only for the super-wealthy, the advent of zero-commission trades and brokers selling fractional shares of stock has opened the door to a wider audience. Is direct indexing something you should consider for your portfolio?
What is direct indexing?
Also known as personalized or custom indexing, direct indexing is directly buying stocks that reflect holdings in a major index fund (like the S&P 500). This is different from buying an index mutual fund or ETF that tracks the index. Once you’ve purchased the majority of holdings you can tweak companies or percentages in an attempt to beat the index instead of merely tracking it.
Your first thought may be, are you crazy? Buying stocks in 500 different companies in the same percentage as an index would be a time-consuming nightmare. And yeah, honestly it would be if you had to do this on your own. But brokers are starting to fill the pipeline with ready-made products like a total stock market index or a focused small-cap index.
Tech to the rescue
Technology may help you reduce the need to purchase 500 shares to a more “manageable” number. Companies have analyzed correlations between stocks within different indexes. Using the S&P 500 as an example, recent results have shown that someone could own one out of five companies in this index and still closely match the overall returns at the same level of risk. One concern of note though – companies change. What may be closely correlated this year may not be as close next year. If you are able to take advantage of software that identifies the stocks you need to own to mimic an index, make sure you discover how often it’s updated and how you receive those updates so you can make any necessary edits to your portfolio.
Benefits of direct indexing
Some of the benefits of direct indexing include:
Potential for better returns. You may receive better returns than with an index fund for two main reasons.
Tax advantages. When you own stocks, you make the decision about buying or selling shares. With a mutual fund, you often are stuck with capital gains distributions at the end of the year. Similarly, you can take advantage of tax-loss harvesting where you sell some of your losers to offset gains in other shares you may own.
You can choose how to balance the portfolio. In recent years, technology stocks have largely provided outsized movement in the S&P 500, both positive and negative. Adding to or reducing the percentage of tech shares could help you differentiate from the index returns. Of course, if you guess wrong you could end up with lagging results.
Align portfolio with your values. More and more, people are choosing to invest in companies that mirror their values. For instance, investors may purchase shares in electric car companies not only because of the potential for market growth, but also because they wish to invest in something that reflects their stance on the environment. With a direct index, you can choose to include companies that mirror your values and omit companies you don’t agree with.
Reduce portfolio overlap. Publicly-traded companies often provide the opportunity for employees to purchase shares for a reduced price. If you’ve worked for a national bank for most of your career, you may have a large portion of your portfolio in your bank’s stock. To reduce the danger of over-concentration in the financial industry, through direct indexing you could reduce or eliminate mortgage companies, banks, brokerages, and other similar company stocks.
Disadvantages of direct index investing
As mentioned above, many of you may have already decided this is way too much of a headache to even consider, especially given how busy your life may already be. Other disadvantages include:
Costs. You can invest in quality index funds at no or extremely low costs; a quick review found fees that ranged from 0.00% to 0.04%. Two online brokers offering direct investing both required a fee of 0.40%; both also required minimums in the thousands of dollars. You will need to recoup this difference every year by outperforming the index.
Missing out on a winner. If you start with 100 companies and then add or delete based on your values or concerns about concentration risk, you may inadvertently remove a stock from the index that outperforms. Just as tech provided large gains and losses, a few missed opportunities may cause enough damage to severely ding your returns.
Could require a financial consultant. Along with the headache of simply purchasing 100 company shares, rebalancing the portfolio each year to match the index (or choosing not to), understanding which shares to sell for tax-harvesting benefits, or just keeping up with the onslaught of proxy statements could be an administrative nightmare.
Does this make sense for you?
Most financial professionals recommend this only for high-net-worth individuals and only for their investments in taxable accounts so they can take advantage of the tax-harvesting advantages. Even with that said, direct indexing is an active investing strategy. Research has shown that the more people trade the less their return over time.
Also know that index funds often have minimal capital gains exposure and ETFs often less. Before you consider spending the increased fee for a direct index, look into the investments you currently own to determine if you’re still on goal using these investments and to make sure they aren’t distributing large capital gains. Compare them to other indexes to see if you can find a better option. Then and only then would I consider researching more into direct indexing.
Photo by Burak the Weekender