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The Relationship Between Direct Indexing and Active Management

Scott's Column

Last month I described what direct indexing is and how advisors might use it to satisfy specific client needs. This month I want to briefly explore the differences between direct indexing and traditional active management.

Is Direct Indexing Passive or Active Management?

True index investing—or passive investing—involves investing in mutual funds, exchange traded funds (ETFs), or portfolios of individual securities designed to closely track an index. Passive investing is designed to benefit from the “free lunch” of diversification and capture the healthy returns that broad market exposure has historically provided to patient long-term investors.

A passively managed portfolio typically contains most, if not all, the securities in the index it tracks. If a stock is in the index, it qualifies to be in the portfolio. A passively managed portfolio may hold hundreds or even thousands of securities.

Unlike a passively managed portfolio, many actively managed portfolios start with nothing. Securities are added one-by-one based on research conducted by the active manager. The portfolio is built from the ground up. Each security must earn its place on the team.

Alternatively, an actively managed portfolio may start with a broadly defined universe of securities, like an index, which is then modified to exclude or weight certain securities or security types in a manner designed to achieve the portfolio manager’s objectives.

Either way, the active manager’s goal is to create a portfolio of individual securities that will (1) outperform a relevant benchmark, like an index, or (2) achieve specific investment objectives that cannot be achieved at all, or as well, by strictly tracking an index.

Since the first step in creating a direct indexing portfolio is selection of one or more indexes for the portfolio to track, it has characteristics of passive investing. But the typical direct indexing portfolio will not hold every stock in the indexes it tracks. Instead, it holds a representative sample allocated by the manager to mirror the industry and sector composition of the indexes.

In addition, the direct indexing portfolio is customized to meet the needs, values, and preferences of the investor. Depending on the level of customization, the portfolio’s holdings and performance may depart significantly from that of the indexes used to establish the baseline portfolio. This gives it characteristics of active management.

So, direct indexing is a hybrid form of investing that combines elements of both passive and active management. But since direct indexing always involves some level of customization and intentional deviation from the index, it is a form of active management.

How “Active” Should a Direct Indexing Portfolio Be?

The role of a direct indexing portfolio manager is different than that of a traditional active manager. A direct indexing manager can:

  • Assist an advisor in developing an asset allocation strategy for their client.
  • Assist in the selection of indexes to implement that strategy.
  • Assist in the selection and articulation of the client’s customization choices.
  • Help manage the balance between tracking error and customization.
  • Create a portfolio that mirrors the performance of the selected indexes, while reflecting the client’s customization choices—this process is sometimes called “optimization.”
  • Manage the portfolio in accordance with the client’s customization choices, while generating potential tax benefits for the client through ongoing tax management.
  • Assist in the selection of mutual funds, ETFs, and other investments to complement the direct indexing portfolio and achieve the client’s overall asset allocation strategy.

Notably absent from the list is screening the stocks in the portfolio based on the manager’s assessment of their likely future performance. In other words, direct indexing portfolio managers are not stock pickers. The modifications they make to the indexes they track are based on optimization software, client customization choices, and tax management needs, not the manager’s determination of likely winners and losers.

In any given year, every index will contain some stocks that generate positive returns and some that generate negative returns. The presence of winners and losers in an index is to be expected—in fact, it is unavoidable. Every direct indexing portfolio will contain winners and losers since its composition mirrors the composition of the index.

Investors who want to pursue actively managed stock-picking strategies designed to outperform broad market indexes, should seek an experienced manager with an investment process designed to achieve that result. A direct indexing portfolio can be paired effectively with actively managed stock-picking strategies, but the direct indexing portfolio, itself, is not the right vehicle in which to pursue this approach to portfolio management.