What Is Direct Indexing?

Written By: Nick Ziarek, CFP®, CFA

The investment world is always evolving and along with that comes new products and strategies for investors to choose from. The first mutual fund was created more than 100 years ago, while John Bogle – the founder of Vanguard – created the first index mutual fund in 1975. It wasn’t until 1993 that the first Exchange-Traded Fund (ETF) was launched.

A new approach starting to work its way into the conversation is called Direct Indexing. While an ETF is essentially a basket that contains a mix of underlying investments like stocks and bonds that investors can purchase shares of; Direct Indexing allows investors to create custom baskets meeting their specific needs. What really sets it apart is instead of holding shares of the basket, investors directly purchase the individual stocks or securities that make up their chosen index.

ETFs vs. Direct Indexing

Key differences between the two strategies include:

Customization: ETFs offer a fixed basket of investments, limiting customization to the broad-based strategy selected. With direct indexing, you can tailor your investment to meet specific goals, values (such as ESG), or tax strategies.

Tax Efficiency: Direct indexing can be more tax-efficient due to the ability to manage capital gains and losses at the individual security level through strategies like tax-loss harvesting.

Cost: ETFs generally have lower management fees and are simpler to manage, making them easier to invest in for all investors. Direct indexing typically involves higher management fees and requires a larger investment, making it more suitable for higher net worth investors.

Accessibility: ETFs can be bought and sold by anyone on the stock market, similarly to stocks. Direct indexing often requires the services of a managed platform that specializes in this type of investment, knowledge of what you want your custom basket to look like, and you directly hold hundreds of underlying securities, making it less accessible.

Tax Efficiency

ETFs have long been known for their tax efficiency, primarily due to their unique structure and the way they manage transactions. ETFs can add or remove low cost basis shares through a process involving large institutional investors that does not require the actual buying and selling of portfolio securities. This process helps limit the realization of capital gains because the ETF can hand over securities in-kind to redeeming institutional investors, avoiding the need to sell securities in the market and realize gains. Many ETFs, especially those that track indexes, tend to have lower turnover rates meaning fewer taxable events, contributing to better tax efficiency. Consider some of the largest S&P 500 tracking ETFs (SPY, IVV, VOO) have not paid out a capital gains distribution in over 20 plus years.

While some ETFs may not pay out capital gains, they also limit the ability for the investor to realize losses especially on holdings held for very long time periods.

Direct indexing offers a higher level of tax management flexibility compared to ETFs. Tax-loss harvesting is a strategy where investors sell securities that have experienced a loss to offset taxes on gains and income. With direct indexing, you own the individual securities rather than shares of the basket. Customizing the investment strategy not just for performance or ethical considerations but also for optimal tax outcomes can potentially reduce your taxable income significantly. For instance, you can avoid buying securities with upcoming taxable distributions or selectively sell securities to manage your overall tax bracket.

Owning individual securities also allows you to control the holding period for each investment. Long-term capital gains (on investments held for more than a year) are taxed at a lower rate than short-term capital gains. Through direct indexing, you can strategically decide when to sell to benefit from lower long-term capital gains tax rates.

Direct indexing provides more control over individual investment decisions, which can be leveraged for tax optimization. ETF investors have no control over the fund’s trading decisions.

The increased tax efficiency, though, comes with greater complexity and potentially higher costs. The strategies are typically professionally managed using sophisticated software to monitor the tracking error of investments to a targeted index, how and when to optimize tax loss harvesting and not run afoul of IRS wash sale rules.

Risks

Direct indexing is not without risks. The strategy and implementation is more complex than simply buying a mutual fund or ETF and requires ongoing monitoring and rebalancing.

Because it aims to replicate the performance of a chosen index by purchasing the underlying securities, it can lead to significant tracking error which is the divergence in performance between the personalized portfolio and the index. Factors like rebalancing costs, timing, and the exclusion or underweighting/overweighting of certain stocks for personal reasons, overemphasis on tax considerations, or even concentration risks all contribute to tracking error.

Conclusion

To sum up, if you’re looking for broad exposure to the market with a relatively low cost and high tax efficiency, index tracking ETFs are a great option. If you have more specific investment goals, values, or need for tax management, the benefits of direct indexing could be the better choice for investors in the highest tax brackets and those with large taxable investment accounts (not tax-deferred like IRAs or tax-free Roths), as the potential tax savings can outweigh the costs involved.

Your Shakespeare Advisor is happy to answer questions about the investment management plan for your personal situation.