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Understanding Direct Indexing

Scott's Column

Direct indexing portfolios are broadly diversified portfolios of individual stocks that are personalized to meet the needs, values, and preferences of an investor.

An Index Oriented Approach

As its name suggests, direct indexing takes an index-oriented approach to investing. The investor, in consultation with their advisor, selects one or more broad market indexes, and the portfolio is managed to track those indexes.

There are many mutual funds and exchange traded funds (ETFs) that allow investors to gain exposure to broad market indexes. Those funds hold most, if not all, of the securities in the index. They may hold hundreds or even thousands of securities.

But what if an investor wants an additional level of customization?

This can be hard to do using only mutual funds or ETFs because an investor has no control over the purchase or sale of specific securities held within the fund.

That’s where direct indexing can help. Since the investor holds the individual stocks, the portfolio can be modified to meet the investor’s needs, values, and preferences.

Customization Options

There are many ways to customize a direct indexing portfolio:

Express Your Values. An investor can screen out companies or industries that engage in activities they do not wish to support. Or an investor can overweight their portfolio toward companies or industries that engage in activities they do wish to support.

Express Your Preferences. An investor can tilt their portfolio toward stocks of companies with specific investment characteristics. For example, they can overweight their portfolio with low volatility stocks, stocks of small emerging companies, or stocks that pay higher dividends.

Reflect Your Personal Situation. An investor can incorporate existing legacy holdings into their direct indexing portfolio. Or, if they already have significant exposure to a particular stock—their employer’s stock, for example—they can limit or eliminate that stock from the portfolio.

Charitable Giving. By donating specific tax lots with the most built-in gain, an investor can meet their philanthropic goals, while maximizing the tax benefits.

Tax Loss Harvesting. An investor’s portfolio can be managed to intentionally generate tax losses that can be used to offset taxable gains, thus potentially lowering their year-end tax bill.

What You Should Know

Winners and Losers. There will be no effort made to pick winners or avoid losers. The goal is to provide investors with broad market exposure, so they benefit from the overall market’s return.

Since the broad market always contains winners and losers, the portfolio will too. Over time, some of the winners will become losers and some of the losers will become winners as individual companies, industries, and economic sectors cycle in and out of favor. Historically, however, the broad markets have produced solid long-term returns for investors.

Cost. Direct indexing portfolios usually have lower expenses than traditional separately managed accounts. But because of the level of personalization required to build and manage direct indexing portfolios, they may cost more than a portfolio built using mutual funds or ETFs.

The difference may not be significant, but each investor should consider whether any additional cost is justified by the benefits of customization and tax management.

Tracking Error. A direct indexing portfolio will not hold every stock included in the index it is designed to track. Instead, the portfolio manager will use a process called “optimization” to select a representative subset of those stocks intended to mimic the performance of the index.

Since the direct indexing portfolio and the index will not have the same holdings, there will be some deviation in their performance. The difference is measured in terms of “tracking error.”

The level of tracking error will depend on factors such as the size of your account, the index your portfolio is designed to track, and the level of customization you choose.

Tracking error is neither good, nor bad. But investors should be aware they are likely to experience more tracking error as they increase the level of customization of their portfolio.

An Excellent Solution

Direct indexing is not right for every investor, but it can be an excellent solution for investors with customization and/or tax management needs, who are comfortable with an index-oriented approach to investing.