Direct Indexing: The Next Big Thing?

November 05, 2019

Questions To Consider

Five questions I’m mulling right now:

1) Is direct indexing active management in disguise? I’m not here to argue whether active management is good or bad. It’s a tired debate and you can research the numbers on your own. The question to consider is, “What happens when you start tinkering with an established index?” At some point, these exclusions cause your investment experience to deviate from the index. That’s active management! Are investors prepared to accept different returns? More importantly, what will this entire process look like? When you start considering the hypotheticals, direct indexing can quickly turn into active management. Again, that’s not necessarily good or bad, but it is exactly what investors have been running from the past 10 years.

2) Will investor behavior be better, worse or the same? If direct indexing causes a portfolio to deviate from its benchmark, will an investor stick with it? On one hand, you can make the case that customization results in better behavior because investors feel more attached to their portfolio. On the other hand, emotional attachment could result in biases that cause worse behavior. If a portfolio is significantly underperforming, will investors continue holding? Will they tinker more? With direct indexing, everything is available at the click of a button. The ease of including or excluding stocks could bring out the very behaviors investors should avoid. Imagine the scenarios across the thousands of stocks available. As an aside, with the way direct indexing is currently set up, investors receive account statements itemizing every single stock they own. Instead of a statement showing several mutual funds or ETFs, they’ll receive a statement itemizing all 500 stocks! Will this impact behavior at all?

3) How much will direct indexing cost? For 9 basis points, investors can purchase the Vanguard Total World Stock ETF (VT) and own around 8,200 stocks, essentially covering the world’s stock market. Every major asset class around the globe is readily available in an index mutual fund or ETF, in many cases for less than 20 basis points. While the costs of direct indexing are still unclear, RIABiz reported a mass market product is likely to fall in the range of 0-35 basis points. There are currently providers charging 25 basis points. Plus, every time an individual stock is bought or sold, investors pay a bid/ask spread. Spreads are typically pennies, or even fractions of pennies, but can add up over time as transactions pile up from stock exclusions, buying replacement stock proxies, tax loss harvesting, etc. The value proposition of a low-cost index fund is tough to beat. The fund handles all of the trading and rebalancing, changes to the underlying index, accounting for corporate actions, optimizing tax efficiency—all for a few basis points. Will the fees of direct indexing be worth it?

4) What are the real tax benefits of direct indexing? The argument for paying direct indexing costs ultimately hinges on tax alpha. However, it’s important to first state the obvious: The tax benefits of direct indexing only translate in taxable accounts. The vast majority of individuals’ investable assets are held in nontaxable accounts. Putting that aside, the ability to create tax alpha is dependent on the performance of the markets overall. If the stock market is up big, there may be fewer opportunities to sell losers. If the market is down and there are plenty of losers, at some point, you run out of stocks to sell—there aren’t infinite losing stocks in your portfolio (at least you hope not!). Also, the more you tax loss harvest, the more potential tracking error you create (see 1 & 2 above). You can also tax loss harvest using ETFs. By the way, with direct indexing, the Form 1099s generated are a CPA’s worst nightmare. Investors could easily receive 1099s hundreds of pages long!

5) Are we coming full circle back to the superstar investment managers of the 1980s? If we hurtle towards a future of direct indexing, what’s the differentiator among direct indexing providers? Our research is better than the competitors? Our factor analysis is better? Our ESG screens are better? We have better technology to give you that total Tesla or Netflix experience? We do a better job of tax loss harvesting? All of this makes me wonder whether direct indexing is a revolution or a move back to the old days where asset managers marketed their track record and ability to generate alpha. Maybe that’s not a bad thing, but again, investors have been moving away from this model en masse.

Inevitable Development

There’s no question that direct indexing will be part of the future investment landscape. The buzz around direct indexing makes sense. Asset management has become increasingly commoditized, and the need to “show value” is creating stress among advisors and investment managers. Add in a world where consumers expect a tailored approach in nearly every aspect of their lives, and direct indexing appears as the perfect solution to deliver that customized investing experience.

Advisors have the opportunity to learn about the specific desires, fears and wishes of clients. Direct indexing also likely reduces the chances that a client goes elsewhere. Think about how messy it might be if an investor wants to unhook and go back to using mutual funds or ETFs. The question to ask is whether personalization and customization is a positive when it comes to investing. Is higher touch better than lower touch? Is the overall value proposition of direct indexing a positive one for investors?

The answer to many of the questions could simply be, “it depends.” For most investors, owning the S&P 500 via an ETF might make the most sense. For others, their unique situation or strong ESG views may make direct indexing the better solution. But as Morningstar’s Ben Johnson put it in a recent meme he tweeted out: “Direct indexing is neither direct nor indexing.”

Follow Nate Geraci on Twitter @nategeraci

Find your next ETF

Reset All