Index investing works
Index investing is not glamorous or exciting. But it appeals to the masses since it allows one to expend energy elsewhere while relying on what works.
Index investing does not make gambles on up-and-coming companies in hopes of outsized returns. Instead, it focuses on buying the whole market and tuning out the hype.
However, a new index investing trend called direct indexing is rising. But more on that soon.
Index composition matters
A sound index investing doctrine focuses on choosing well-constructed index funds from reputable providers in the areas you wish to participate. Generally, these sectors will include domestic and international equities, plus the bond market. Some individuals may get more specific in their allocations, but I suggest starting here.
Since index investors are not trying to beat the market but instead trying to replicate it, any fee added will act as a drag. Therefore, when indexing, expenses and the proper index are far more critical than anything else.
Popular low-fee index fund providers that track reputable indexes include Blackrock, Charles Schwab, Fidelity Investments, and Vanguard. Tickers of some of these funds tracking large-cap US companies include SPY, SWPPX, FNILX, and VOO.
If you want to learn more about fund fees, I suggest reading Active or Index: How to Decide. In this article, I outlined how transaction/commission, load, and expense ratio fees can affect investor returns when utilizing mutual funds and ETFs.
The rise of direct indexing
Index funds have been the cream of the crop for a considerable time. Still, a new form of indexing where one ditches the funds in favor of the underlying holdings is gaining popularity.
Until a few years ago, if one wanted to purchase a stock, they had to fork over the entire share price to receive ownership. However, many companies now offer fractional share purchasing and no commissions, allowing investors to buy a slice of a company cost-effectively.
As a result of the changing brokerage landscape, direct indexing for equities is now available to the masses. For reference, only those with large sums of money could directly index in the past due to the high cost of entry (~$50,000+).
How direct indexing works
Direct indexing works by purchasing each component in an index directly instead of utilizing a mutual fund or ETF. Further, the strategy requires the investor to “weight” each holding according to the index correctly and occasionally rebalance their portfolio.
(Weighting refers to what proportion of an index each holding represents; most indexes weigh according to market capitalization.)
For example, direct indexing in the S&P 500 requires buying approximately five hundred individual companies using fractional or whole shares based on each holding’s market capitalization. As the S&P 500 index changes in composition and value, one must occasionally rebalance to add and remove companies while increasing and decreasing the dollar value allocated to various positions.
Direct indexing requires investors to be more hands-on than when holding an ETF or mutual fund, which otherwise would do this work for them. So, why would anyone go through the hassle of direct indexing?
The benefits of direct indexing
Direct indexing primarily has the benefit of providing tax optimization, lower fees, and increased portfolio personalization.
Unlike traditional index fund investing, direct investing allows investors to tax-loss harvest, which may increase returns in after-tax investment (i.e., brokerage) accounts. Without going too far in depth on tax-loss harvesting, it is the practice of capitalizing on share price capitulations by selling specific holdings for a loss while capturing profits from others. Doing so can lower the investor’s tax bill and increase their returns after paying capital gains taxes. Vanguard research indicates that tax-loss harvesting can yield an extra 1% return for directly indexed portfolios (thanks for locating this analysis, Kiplinger).
Because direct indexing cuts out the middle-man, i.e., the mutual fund or ETF, investors pay zero dollars in expense ratio fees. For those unfamiliar with expense ratios, they are the cost a fund charges to operate itself as a distinct legal business entity regulated by the SEC. However, this point is insignificant for investors with portfolios under ~$10,000,000. After all, the Vanguard S&P 500 ETF (ticker symbol VOO) assesses a 0.03% expense ratio, which costs portfolios of $1,000,000 only $300 annually. Further, Fidelity offers zero expense ratio index funds. Therefore, investors need to weigh how much their time is worth and tally the other benefits, such as tax-loss harvesting and individual personalization.
The final benefit direct indexing provides is portfolio personalization. Proponents of ESG investing or those who disagree with specific company goals/values can exclude particular holdings when direct indexing. For those unfamiliar with ESG investing, I suggest reading my collaboration with Gary Grewal of Financial Fives: Could ESG Investing Fit Into Your Portfolio?
A “passive-active” approach to direct indexing
Direct indexing has benefits but can be time-intensive to establish and manage initially. But, as is capitalism, many companies now offer direct indexing through active management strategies due to fractional trading. Previously, many firms required portfolio minimums between $1000,000 to $500,000 to establish a managed direct indexed portfolio (Charles Schwab, Fidelity Investments, and Wealthfront). Notably, most firms still require high minimums. But Fidelity recently launched a $5,000 minimum portfolio approach called FidFolios, and I expect other companies to follow suit.
With Fidelity’s FidFolios, investors pay a 0.40% advisory fee. Fidelity then builds a portfolio of 150-350 stocks in an after-tax managed brokerage account and actively trades the holdings to account for index changes and capitalize on tax-loss harvesting opportunities.
Fidelity shows a hypothetical model of how their tax-smart direct indexing portfolio strategy could yield investors an extra 6.6% over ten years compared to an equivalent large-cap index after accounting for fees (equating to a 0.66% annualized alpha). However, it is essential to remember past performance is not indicative of future results.
Disclosure: I have no affiliation with Fidelity Investments and receive no compensation for mentioning them. However, I previously worked for Fidelity Investments and still use them as my broker of choice.
Drawbacks of direct indexing
While direct indexing through professionally managed portfolios provides investors with a more passive approach to direct indexing, it defeats the purpose of indexing. After all, you are now relying on active portfolio management and paying increased fees, and I am not alone in this belief.
The CFA Institute corroborates my notion and states that direct indexing is just another way for the asset management industry to increase revenues lost from the popularity of index funds. Further, they remark that customized portfolios are not likely to outperform an index and that tax-loss harvesting is another form of stock picking. So, there are clearly downsides to the strategy.
Is direct index worthwhile?
Direct indexing is an intriguing proposition that could yield better returns for investors due to potential tax benefits while helping them mold their portfolios to their personal beliefs. Still, since direct indexing only provides (potential) meaningful financial value in brokerage accounts, it is neither practical nor time-efficient.
I believe the direct indexing advent for everyday investors is exciting. In the future, I hope that automated trading software will become available to the masses, making direct indexing easier to implement.
Currently, direct indexing is in its infancy and is just another way to spin active portfolio management. Once direct indexing progresses, hopefully through low-cost automated trading software, it could provide a meaningful way to take indexing to a new level (similar to how index funds revolutionized investing).
Let me know your thoughts, questions, and experiences with direct indexing in the comments below, and as always, have a great day!
FAQs
Is direct indexing passive?
Directing indexing in its current form is not passive and instead is a version of active management.
What is direct indexing vs SMA?
Direct indexing is an investment management strategy of buying index components and tax loss harvesting. Meanwhile, an SMA is a separately managed account, which an investment manager runs for clients. An SMA can have a direct indexing, factor-based investing, or other various strategies as its management style.
Mile High Finance Guy
finance demystified, one mountain at a time
