Investors interested in diversifying their portfolios can use direct indexing and ETFs to achieve that goal. While an ETF can be a simpler option, you can exercise more control over your portfolio with direct indexing solutions. Let’s compare the advantages and disadvantages of both for your portfolio. A financial advisor could help you pick the best investment options for your portfolio needs.
What Is an ETF?
An ETF stands for an exchange-traded fund. These investment vehicles track market indices and can be traded like a stock.
For example, many exchange-traded funds track popular indices like the S&P 500 or the Dow Jones Industrial Average. But ETFs can also track smaller indices within a particular industry.
When you purchase a share of an ETF, the value is in the underlying stock of companies within the ETF. So, you could purchase one share of an ETF to own a small piece of all of the companies within a particular index.
What Is Direct Indexing?
Like an ETF, a direct indexing strategy is based on a popular index. But instead of purchasing a single share of an ETF, the investor individually purchases every security within a particular index.
In the past, direct indexing was cost-prohibitive based on the large number of fees associated with trading. But with many brokerage firms now offering a $0 trading commission, direct indexing costs aren’t necessarily a deal breaker.
Beyond the ability to make trades without a cost, many brokerage platforms also offer fractional share amounts. The availability of fractional shares allows investors to consider direct investing, whether or not they have the means to buy a whole stock of each company in a particular index.
ETFs: Advantages and Disadvantages
As with all investment options, you will need to consider the advantages and disadvantages before buying an ETF. Here are three advantages:
Flexibility. You can purchase an ETF like a stock, so it’s possible to buy and sell shares whenever you’d like to. This is a bit easier than selling off the right portion of shares in a direct indexing portfolio.
Diversify with ease. You can purchase a single share of an ETF to quickly get your portfolio off the ground. That’s a sharp contrast to a direct indexing option that requires purchasing an extensive number of individual stocks.
Low investment minimums. You can purchase a single share of an ETF at a relatively affordable price.
And here are two disadvantages:
Fees involved. Within ETFs, there are embedded expense ratios to consider. Although usually low compared to a mutual fund, you’ll need to run the numbers against your brokerage platform if considering a direct indexing strategy.
Possible errors. It’s possible for an ETF manager to track an error at some point. Unfortunately, this could cost investors holding the fund.
Direct Indexing: Advantages And Disadvantages
Before you invest in direct indexing, here are three advantages to consider:
Tax control. When you purchase individual stocks to match an index, you are in complete control of buying and selling. With that, you can potentially take advantage of tax-loss harvesting opportunities.
Customize your risks. With direct indexing, you can treat a particular index like a roadmap. But if you spot other opportunities along the way, you have the opportunity to adjust your portfolio to match your risk tolerance.
Lower costs. If you are up for managing the buying and selling of individual stocks on your own, you can potentially save money with a direct indexing strategy.
And here are two possible disadvantages:
Active management is required. You can just set your direct indexing strategy on autopilot. Instead, you’ll need to regularly rebalance and replace stocks along the way.
Fractional share issues. Most investors must use fractional shares to make a direct indexing strategy work for their budget. If you must use fractional shares, that will limit which brokerage platforms will work for you.
Bottom Line
ETFs are generally a great choice for beginner investors due to their ease of use. But if you want more control over the tax strategy of your investment portfolio and have the time to commit to tracking an index, then a direct indexing strategy could work well.
Investment Tips
- A financial advisor could help you build an investment portfolio to support your financial future. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s free investment calculator can help you visualize how your investments could grow over time.
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