The Pros and Cons of Direct Indexing

The Pros and Cons of Direct Indexing

ETFs have been the fastest growing product in the asset management industry. Since 2003, their assets have increased by over 30 times and currently stand above $5 trillion. And that is likely just the beginning. A recent Bank of America report projected that ETF assets will reach $50 trillion by 2030.

The rapid growth of ETFs is a direct result of the many benefits they provide investors.

Not only do ETFs offer investors the ability to keep fees low, but they also allow them to defer taxes until they sell their shares and to avoid capital gains distributions, which is a major advantage relative to both separately managed accounts and mutual funds. For investors who hold ETFs for the long-term, this tax deferral can result in significantly higher returns. There are few free lunches in investing, but for taxable accounts, ETFs are one of them.

The benefits of ETFs certainly haven’t been lost on investors with assets growing as quickly as they have in recent years. But there is a looming threat to ETFs that some industry experts think may challenge their dominance down the road.

The combination of new technology, the elimination of brokerage commissions, and the ability of investors to purchase partial shares of individual securities have come together to create a product that some experts think is superior to ETFs.

That product is direct indexing.

Direct indexing offers investors the ability to build a custom index of stocks specific to their personal situation.

This has several major advantages:

First, it can allow for improved tax efficiency, even when compared to the long-term tax deferral offered by ETFs. The reason is that ownership of individual securities allows for tax loss harvesting that can generate tax losses, even when the portfolio itself is producing gains. The ability to intelligently replace those sold positions with similar positions can allow this process to occur without leading to major deviations from the index you are trying to track. In the right situation, it can be a win-win for the end investor.

Second, direct indexing allows for the customization of a portfolio that meets the exact needs of each investor. For example, if a married couple work at Google and Facebook and have large positions in both and also want to customize their portfolio based on their views on environmental issues, they could build a custom version of the S&P 500 that excludes Google and Facebook and also excludes companies that are not environmentally friendly. And since brokerage commissions have fallen to zero and partial shares are now widely available, they can build this portfolio to their exact specifications without any direct trading costs. They can even do so in a very tax efficient manner by harvesting tax losses each year.

If you are thinking that all of this seems too good to be true, you are right. But you are also wrong. Like many things in investing, direct indexing has both advantages and disadvantages. It also has some situations where it makes a lot of sense and others where it does not.

We have taken a detailed look at direct indexing in recent months as we worked to build our own suite of products in the area and I wanted to share some of the things we have learned along the way.

Here are some things to keep in mind when looking at direct indexing strategies.

It Can Boost After Tax Returns in the Right Situation

As I mentioned before, the ability to harvest losses can be a significant positive and can lead to after tax returns that are actually higher than pre-tax returns. There are a few caveats that come with that, though. The first is that loss harvesting can’t go on forever. The market goes up more than it goes down and over time the percentage of the portfolio with losses will fall, and the benefit to loss harvesting will fall with it. So the tax benefit typically falls with time and eventually reaches a point where it no longer exists. After that, any difference between the fees of a direct indexing portfolio and the fees at which you could access the same index in an ETF begins to offset the previous tax benefit.

The second important point to keep in mind is that the tax benefit is a function of each individual’s tax rate and whether they have gains elsewhere to write off the losses against. When you see after tax returns quoted, they typically will be for an investor in the highest tax bracket. Investors in lower brackets can still get tax benefits. They just won’t be as great. Writing off losses also requires gains to write them off against (at least beyond the small annual minimum). For an investor who doesn’t generate taxable gains somewhere else, direct indexing makes less sense.

Behavior Can Be a Big Benefit

The ability to customize a portfolio is a double-edged sword. On one hand, there is an inverse relationship between an investor’s ability to make changes and their returns. Many studies have shown that the investors who perform best are often the ones who make the fewest changes. But having said that, in this case I think the customization offered by direct indexing is likely to be a good thing, as long as it is used with a set it and forget it approach and not as a means to make frequent adjustments. The reason is that all of us are more likely to stick with an investment strategy we believe in. I think this is even more true if we are able to play a role in the creation of the strategy based on our personal beliefs. And direct indexing takes things like ESG customization a step further by allowing each investor to create a definition of ESG that fits their personal beliefs. Even if these customizations end up hurting actual returns, they can still boost investor returns if they make investors more likely to stick to their investment strategy. This has the potential to be a major benefit of direct indexing.

Turnover Can Be the Enemy of Tax Efficiency

When direct indexing is used with a simple, low turnover strategy like the S&P 500, the added turnover above and beyond the standard index can be a good thing when that turnover is used to harvest losses. When you start adding factors like value and momentum, though, things get more complicated. These factors require turnover to work. But that turnover can require positions to be sold that have taxable gains. That reduces tax efficiency. For example, if a high momentum stock sees its momentum break and that position has a taxable gain, the goals of tax efficiency and getting the most out of the factor begin to conflict with each other. This process can be managed to some degree, but in general, increased turnover will typically lead to decreased tax efficiency.

The Details are Important

Like any investment strategy, the devil is often in the details with direct indexing. Although direct commissions have largely gone away, indirect trading costs have not. So the increased turnover of these strategies makes trade execution very important. Tracking error is also a significant consideration. Whenever a stock is sold to generate a taxable loss, it can’t be bought back for 30 days due to the wash sale rule. To continue to track the index as closely as possible, it has to be replaced with something else. Figuring out what that something else is can be challenging since no two assets are the same. If this process isn’t handled properly, it can lead to deviation from the index you are trying to track.

The Road Forward for Direct Indexing

I went into my examination of direct indexing as a skeptic. But the more I have looked at it, the more I have come to understand its benefits. Like any investment strategy, it has its plusses and minuses and will work for some investors, while making much less sense for others. For investors in high tax brackets who prefer a customized index to a plain vanilla one, it can be a superior solution to funds and ETFs. For retirement accounts or investors in lower brackets, it likely makes less sense. But either way, I think direct indexing is here to stay and will likely play a major role in investor portfolios going forward.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.