ETFs made their debut in the ’90s as a popular security that allowed investors to have an alternative to traditional stock purchases and mutual funds. Through ETFs, investors could obtain a passively managed portfolio with no minimum investment and various assets. Today, ETFs are still a popular option but quickly becoming outpaced by the benefits direct indexing offers. Below we’ll take you through why this shift in preference is occurring as well as give you a high-level overview of direct indexing and all it can offer you.
For professional help in choosing the right investment option for you, find a financial advisor who serves your area to assist you.
Direct Indexing Definition
Direct indexing is an investment vehicle that allows you to purchase individual stocks or securities which track the performance of an index like the Dow Jones Industrial Average or the S&P 500. For example, if you wanted to create a portfolio that could perform just as well or better than the popular S&P 500 index you could use the direct indexing tactic for the task. You would select all of the securities that the S&P index holds and copy their weights.
Certain ETFs, in allowing investors to buy buckets of investments that mirror particular indexes, can have similarities to this process, but there are distinct differences.
ETFs vs. Direct Indexing
To understand direct indexing vs. ETFs you need to look at the commonalities they share and the differences that separate them. First, direct indexing and ETFs both allow investors to own a pool of individual securities like stocks and bonds. The design is set up to produce the best return possible by mimicking the success of the most prosperous indexes in the market.
The main difference lies in the ownership of the securities. An ETF allows you to own a share of the ETF, not the individual securities. With direct indexing, investors own the securities and can manipulate their weights as they see fit.
Benefits of Direct Indexing
Now that you have a better grasp on the differing structure of direct indexing and ETFs we can move into the reasons why direct indexing is gaining popularity over other offered investment vehicles. The first benefit is the most obvious, customization.
ETFs offer flexibility, allowing you to buy and sell shares as you see fit. However, direct indexing allows the same flexibility coupled with the ultimate freedom of customization. As we mentioned above, direct indexing permits investors the freedom to buy all the individual shares of stock that other indexes have, but they can diversify as they see fit. This includes buying additional shares or selling off ones that aren’t performing as well. By having the freedom to remove poorly performing assets, investors have a better opportunity to outperform the index they’re mimicking.
Reduced Tax Cost
Whenever a single stock is sold for a profit, the seller must pay a tax on the income. This is known as a capital gains tax. On the other hand, if an asset sale was made and it resulted in a loss, the seller can claim a loss on the sale. This translates into a tax deduction where the loss is deducted from your taxable income. The lower your taxable income, the lower your tax bill.
So the reasoning stands, claim all of your losses to minimize capital gains taxes on investments.
With direct indexing, there is a plethora of opportunities to sell a security at a loss in order to offset your gains and lower your tax bill. This process is commonly referred to as tax-loss harvesting.
In the past, direct indexing was hindered by the lack of platforms willing to support it. According to Cerulli Associates, “Direct indexing is primed to grow at an annualized rate of over 12% over the next five years, faster than traditional financial products, such as mutual funds, ETFs and separate accounts.”
Recently, asset managers and large firms like JPMorgan, BlackRock and Vanguard have taken notice of this increasing popularity. As a result, more platforms are adopting specialized portfolio capabilities to support direct indexing.
Investors can now more easily pursue direct indexing as their primary form of investing without the downsides of restricted fractional share purchasing and platform restraints.
Challenges of Direct Indexing
Before deciding to compete with index funds, be aware of the challenges and responsibilities involved.
While index mutual funds and ETFs are largely hands-off, direct investing portfolios must be actively managed. The account owner needs to rebalance, replace stocks when indexes change and take advantage of tax benefits. In other words, this is probably not something for the passive investor. Falling asleep at the wheel, so to speak, could be expensive.
Because you are purchasing individual stocks to replicate the index, most portfolios will need to purchase fractional shares based on the size of their balance or ongoing contributions. Not all brokerages are set up to handle fractional shares. Some investors have to change brokerage companies to implement this strategy.
Performance Tracking Challenges
ETF and mutual fund investors receive relatively simple statements with just a handful of ticker symbols to track. Comparing mutual fund and ETF performance to indexes is easy to do. With direct indexing, your statement may contain hundreds of individual stocks. This makes it more challenging to track overall performance and to compare against an index.
The Bottom Line
ETFs can give you a group of securities to mimic an index but possess restrictions in security choices and weights. For more flexibility, customization and overall control of your portfolio, direct indexing can make a great addition to your investment strategy.
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