Direct Indexing: The Next Big Thing?

November 05, 2019

The “Future of Investing.” The “Great Unwrapping.” The “ETF Killer”! The financial industry never lacks innovation and, apparently, the next big thing is here: direct indexing.

A typical index mutual fund or ETF owns the components of a market benchmark in a single, bundled product. For example, an S&P 500 Index fund holds approximately 500 of the largest U.S. companies weighted by market capitalization. A Dow Jones ETF holds a price-weighted basket of the 30 stocks representing the Dow Jones industrial average.

Pretty simple. Any investor owning these funds has the exact same experience. Index funds and ETFs have mushroomed in popularity due to their typically lower costs, tax efficiency, diversification and performance.

Direct indexing removes the fund “wrapper.” Instead of owning around 500 of the largest U.S. companies or the 30 Dow Jones constituents in a single fund, investors hold all 500 or 30 securities individually. They directly own the index components. Why do that?

Why Direct Indexing?

Let’s say you work for Amazon, currently the third largest holding in the S&P 500. Should you also own Amazon stock in your investment portfolio? That didn’t work out so well for employees of Enron or Lehman Brothers. Let’s also say you absolutely despise the idea of investing in weapon manufacturers.

Direct indexing allows you to own the S&P 500 minus those stocks. We’ll call your customized index creation the S&P 485 ex-Bezos & Guns! You can tailor even further if desired, applying factor tilts (think value or momentum) or by building an index around low-cost basis stock positions you already own. Sounds great, right? But, wait, there’s more!

There’s the potential for tax alpha, or enhancing your returns by taking advantage of tax loss harvesting. In direct indexing, tax loss harvesting occurs at the individual stock level. You can sell losing positions, offsetting gains elsewhere, which could allow more money to stay invested (since you’re not paying taxes) and compound over time. Another possible benefit accrues to retirees, who have the ability to selectively sell holdings with the least (or zero) tax impact.

Direct indexing also avoids capital gains distributions inherent in mutual funds and ETFs (a much bigger issue in mutual funds, though still possible in an ETF). Lower-income investors could harvest individual stock gains, allowing them to pay lower tax rates on realized gains than they might otherwise be on the hook for.

Widening Availability

Direct indexing isn’t a new concept. It’s actually been around for decades in the form of separately managed accounts, primarily available to institutional investors. However, a rapidly evolving and highly competitive financial services landscape, along with technological advancements, is now making direct indexing viable for the masses.

One of the biggest obstacles preventing direct indexing from going mainstream has been commissions charged by brokerages for the purchase or sale of any stock. If an investor wanted to direct-index the S&P 500, it could cost a cool $2,500 (500 stocks at $5/trade) just to set up the portfolio. That doesn’t include any ongoing portfolio maintenance—rebalancing, tax loss harvesting, etc. That obstacle has disintegrated with all of the major brokerages recently offering commission-free trading.

Another major hurdle has been the inability of investors to purchase fractional shares of stocks (i.e., less than a single share of a company’s stock). Consider Amazon, which currently trades around $1,800/share and has a 3% weight in the S&P 500. To replicate the index, investors need a substantial balance to make direct indexing feasible. It appears as though fractional shares are the next shoe to drop at major brokerages, with most allowing trading in fractional share, thus removing this issue.

Commission-free trading and fractional shares, along with significant advancements in the technology underpinning direct indexing, mean the ingredients are now in place for the next investing revolution. But is it truly a revolution, or are we actually coming full circle back to the 1980s?

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