Direct indexing is a hot strategy for financial advisors looking to differentiate themselves to potential clients – but what is it and when does it make sense for clients?
The idea behind indexing, of course, isn’t new. Vanguard Group founder John Bogle created the world’s first index mutual fund in 1975 when he launched the Vanguard 500 fund, which did nothing more than track the stocks listed in the Standard & Poor’s 500 Index. Instead of a complex scenario in which fund managers picking individual stocks, the index was simple for investors to understand, provided broad-based exposure to U.S. equities and was cheap to run, resulting in lower fees.
As of 2021, there were 7,481 mutual funds in the U.S. – and that total was a drop from 2020. But despite a plethora of indexes fund managers could follow, funds were still aiming to cover a broad mix of stocks. The advantage of custom indexing – also called direct indexing or personalized indexing – eschews the one-size-fits-all approach to create an index designed to meet a the goals of a single investor. Custom indexing can be a great way investors to content with a challenging market and will be increasingly popular, as O’Shaughnessy predicts that by 2025 most financial advisors will have software to manage custom indexes.
For more assistance working custom indexing into your financial plan, consider working with a financial advisor.
What Is Custom Indexing?
A custom index is set up as a separately managed account for an investor that directly purchases individual stocks. Those selections are based on an existing index, then adjusted and tweaked using sophisticated software to match the needs, circumstances and priorities of the individual account-holder. These accounts carry higher fees, of course, and are best suited for high net-worth individuals with substantial portfolios who can benefit from a range of customized options, particularly in four scenarios.
Tax-loss harvesting: Even when a given index is up some of its individual stocks are trading at a loss. Because the investor in a custom index holds individual stocks, it’s possible to sell off those shares that are down, creating a tax loss that can be used to offset the taxes due on the overall gain of the index. Another advantage is being able to separate long-term and short-term losses and gains within the index.
ESG investing: Socially conscious investors concerned about the environmental, social, and governance polices and standards of the companies that make up their holdings. Unlike investing in a standard index, a custom index can be designed to avoid shares of firms involved with fossil fuels or weapons, for example, to include firms that promote diversity and inclusion, or to bypass companies with particular political ties or a history of illegal behavior.
Factor investing: Investing in companies with specific characteristics – “factors” – such as value, rapid-growth or in highly specialized market segments is difficult to achieve with a standard mutual fund or ETF. With virtually any individual stock available, a custom index can be tailored to meet those criteria.
Diversification: Standard indexes built around growth, value or some other factor can end up overly concentrated in certain sectors, such as technology. In addition, a senior executive may be required to hold a significant number of shares in his employer. A healthcare CEO, for example, can create a custom index.
Bottom Line
Custom indexing entails creating a separately managed account for an investor that directly purchases individual stocks. This technique is growing in popularity among financial advisors who have the software to personalize this strategy to meet the needs of the investor.
Tips on Investing
- Investing, whether in custom indexing or buying individual stocks, can be complex. Sometimes it helps to have an expert at your disposal. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- In addition to working with a financial advisor be sure to make use of our free investment calculator to give you a quick estimate of how your portfolio will do over time.
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