Direct Indexing

I have written about the value of broadly diversified portfolios, and how Mutual Funds and ETFs (and investment trusts in general), make such portfolios accessible to individual investors. It’s also possible to construct broadly diversified portfolios in individual accounts. This method, also known as direct indexing, has traditionally only been accessible only to  ultra-high-net-worth individuals, who have used it to great personal advantage. Recent improvements, however, have made direct indexing more accessible to the (merely) high-net-worth.

In this article, I discuss some of the barriers to creating broadly diversified portfolios in individual accounts, how those have lowered over time, and discuss some of the potential benefits, trade offs, and considerations involved in choosing a direct indexing approach.

Direct Indexing is an approach where an individual, using the services of a money manager, directly purchases a statistical representation of an index (or indices) as individual holdings in their portfolio. This approach gives the investor the performance and low costs associated with indexing, but also provides benefits that aren’t available in Mutual Funds or ETFs.

Why has this been challenging until now?

A number of things have historically been challenging for individuals attempting to create broadly diversified portfolios within their individual accounts.

Representation (aka “Tracking Error”)

It would be very expensive to buy all the individual shares, in the appropriate ratios, of each of the many stocks one would need to purchase to track even a relatively narrow index such as the S&P 500. It would cost much more to track all the thousands of US and international stocks that aren’t included in the S&P 500. It’s also challenging to invest smaller increments without throwing off the balance (and thus deviating from the index). This is not as big a deal when you’re investing very large amounts of money.

Direct Indexing seeks to construct portfolios using baskets of securities that are statistically similar (within bounds) to the index they track. This allows for smaller initial and ongoing investments.

Trading Costs

Trading is expensive.

• Commissions can eat up a significant portion of the investment when purchasing smaller lots. This is not as big of a problem when working with larger accounts.

• Spreads represent the difference between what shares sell for, and what one would have to pay to buy them. These affect both large and small accounts equally.

Commissions have come down dramatically over the last 5 years. Today, most trades are free, and the pricing on even Over the Counter (OTC) trades is trending towards zero. Spreads have also come down dramatically over the last couple of decades.

Management Costs

It requires time and effort to research and choose appropriate individual securities, and to make the necessary decisions in response to changes in the markets or indices. This is a cost that’s harder to justify for smaller portfolios, but which can be amortized more easily over larger portfolios.

Direct Indexing uses outside money managers, powered by software, to enable individuals to avail of high quality management at relatively low costs.

Benefits of Direct Indexing

Direct Indexing can provide a number of benefits to an individual investor.

Tax Loss Harvesting

S&P 500 Returns in 2021. Source: FactSet via Parametric Technologies

2021 was a great year for the S&P 500, which experienced a positive return of 28.71%. However, 72 of the 500 stocks in the index actually lost value that year, with some losing as much as 50% of their value. 91% of the stocks in the index had drawdowns of over 10% at some point during the year.

S&P 500 Returns in 2022. Source: FactSet, via Parametric Technologies

The index fared much worse in 2022, losing 18.11% overall. 354 stocks lost value over the course of the year, with the biggest loser losing as much as 70% of its value. Additionally, 88% of the stocks in the index had a maximum drawdown of more than 20% at some point during the year. 

Q1 2023 was better for the index overall, with an overall return of 7.5%. However, 91% of the stocks in the index had a drawdown of at least 10% at some point in the quarter.

My point is that regardless of how well an index does overall, there will be individual stocks within the index that will lose value during any given period. Direct Indexing allows you to sell off some of those losers and replace them with other stocks that are statistically identical. These capital losses can be used to offset other capital gains that the individual might have experienced, or may be deducted (up to $3000 a year) from the individual’s taxable income. A number of studies estimate that tax loss harvesting can generate 1-2% of “tax alpha” for investors, after accounting for fees, over the first 10 years of direct indexing.

The goal is not to generate losses for the sake of losses, but to realize the losses an investor would experience as part of their actions to maximize their tax efficiency.

Customization

With direct indexing, an investor is no longer bound to follow an index exactly. Rather, they can customize their holdings in a number of ways:

• Tilts: Investors can choose to apply their own tilts (for e.g towards or against market cap, growth, value, profitability, momentum, etc.) based on their investment philosophy.

• Screens/Weights: Investors can choose to exclude or overweight individual stocks, industries or sectors.

• Timing: Index ETFs are bound to purchase new stocks added to the index they’re benchmarking, and sell off stocks that have been dropped within specific periods – which is also precisely when everyone following that index is also selling off or buying the same stocks. With Direct Indexing, the money manager can choose a more opportune time to make those trades – including before the official entry or departure of the stock.

Not being tied precisely to an index can allow investors to generate better returns in most cases.

Values-Based Investing

Screens or weights can also be used by investors to affirm their values as part of their investing by excluding stocks or industries that don’t align with the investors values.

Investors making charitable contributions can also pick off some of their appreciated positions to maximize the impact of their contributions at the lowest cost to them.

Concentrated Positions

Direct Indexing allows investors to consider their concentrated positions. This is achieved both by excluding the stocks they have a concentrated position in, and by realizing losses that can be used to offset gains from diversification of the concentrated position.

Transitions

Direct Indexing also makes transitions between styles and asset classes more tax efficient. 

An ETF investor who wants to track a different index or style must sell off their holdings to buy a different ETF. This could mean realizing gains and paying taxes on those. With direct indexing, they can retain the positions they would have in common, realizing fewer gains in the process. With asset class transitions, investors can choose to sell off losers, or less appreciated stock instead of having to sell off their entire positions.

Considerations

Minimum Investment Size

Direct Indexing requires a minimum portfolio size in order to build a portfolio that tracks the benchmark well enough. These minimums can over a million dollars for a globally diversified benchmark, though we’ve seen minimums for narrower indices be as low as $100K.

Tracking Error

A corollary to the investment size is the tracking error, or the difference between the direct index and the benchmark it aims to reproduce. The smaller the investment, the harder it is to reproduce the benchmark’s performance. Tracking error can result in under- or over-performance compared to the benchmark. Some of the providers with smaller minimums generate substantial tracking error, to the point that you’re not really reproducing the index meaningfully enough.

Cost

Direct Indexing providers charge management fees ranging anywhere from 20 bps to 40 bps. This is in addition to any trading costs or advisory fees that an investor would incur as part of their portfolio.

Diminishing Returns

The value of tax loss harvesting diminishes over time as the losers get sold off and the investor is left holding only winning positions. At that point, there is no more tax loss harvesting to be had. Direct indexing is most advantageous when an investor is able to continue to contribute to their investment, as it is able to continue to generate losses in that case.

Complexity

Direct Indexing is complex to set up, particularly for investors interested in some of the tilts and screens, and in taking advantage of the advantages for concentrated positions and transitions. Most providers only offer this functionality through advisors.

Direct Indexing will also result in longer 1099-B forms, and more notices related to corporate governance. Some investors might find this mildly inconvenient.

Conclusion

Direct Indexing can provide benefits to high-net worth individuals beyond what holding similar assets in an ETF or Mutual Fund can. However, there are a number of considerations an individual should take into account when deciding whether or not it is the right option for them.

Questions? Comments? Curious about whether Direct Indexing is the right solution for you? Feel free to reach out to me at suhas@prosperowealth.com if you would like to discuss this, or your personal situation, further.