Direct Indexing: The Next Big Thing?

It’s likely direct indexing will be widely available soon, but what will the consequences be for investors?

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?

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