Is Direct Indexing Right For You?

A (sort of) new investment strategy has been receiving extra attention lately: direct indexing. If you’ve read about it, you may be wondering what it is, how it works, and whether it’s worth using for your own investments.

What Is Direct Index Investing?

Direct index investing shares some traits with its more familiar cousin, index fund investing. A traditional index mutual fund or exchange-traded fund (ETF) buys and holds the securities tracked by a particular index, which in turn seeks to replicate the performance of a particular slice of the market.^[1] For example, the Vanguard S&P 500 ETF (VOO) tracks the S&P 500 Index, which approximately tracks the asset class of U.S. large-company stocks.

In direct indexing, you invest directly in most or all of the securities tracked by an index, instead of investing in an index fund that invests in them for you.

How Does It Work?

Let’s say you have $100,000 you’d like to allocate to U.S. large-company stocks, as proxied by the S&P 500. Here’s how you or your investment manager might proceed:

	As an Index Fund Investor …	As a Direct Indexing Investor …
Set-Up	You could buy $100,000 worth of an S&P 500 Index fund, weighted by market-cap. You would then indirectly hold all U.S. large-company stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index.	You could achieve the same exposure to the same collection of U.S. large-cap growth stocks by investing $100,000 directly in the individual stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index.
Management	In your account statements, you would see a single position in one fund representing a U.S. large-cap stock allocation (as proxied by the S&P 500). To hold a larger or smaller allocation to this asset class, you would buy or sell shares of this single fund.	In your account statements, you would see hundreds of different stock positions (or at least enough stocks to accurately emulate the index).^[2] You could then individually buy or sell shares from each position to alter your U.S. large-cap stock allocation.
Tracking	When the S&P 500’s holdings or weights changed in the index, the fund would alter its underlying holdings as well. To continue tracking the index, you simply keep holding the fund.	When the S&P 500’s holdings or weights changed in the index, you would need to place trades across your individual positions to continue tracking the index.
Taxes	When selling fund shares, you’d realize a gain or loss based on how much you paid for each mutual fund or ETF share.	When selling individual stock shares, you’d realize a gain or loss based on how much you paid for each stock share.

Direct indexing doesn’t have to be an “all or nothing” strategy. It’s more typical to implement it for the portion of the portfolio allocated to highly liquid asset classes, such as U.S. large-cap stocks, where it’s easier to routinely buy and sell components. Direct indexing becomes increasingly impractical in markets where trading is more difficult and/or expensive.

Why Now?

Some institutional and similar large investors have been incorporating direct indexing into their portfolio builds for years, usually through Separately Management Accounts (SMAs). As such, the approach is not new, but it has been receiving increased media coverage lately.

That’s likely because direct indexing has become more practical for individual investors. Recently, many trading platforms have: (1) eliminated investor trading fees that made it cost-prohibitive to buy and sell so many individual securities; and (2) allowed fractional share purchases, making it possible to capture an index’s holdings in smaller slices. As a result, more providers are offering direct indexing services to smaller accounts for relatively modest fees.

Why Do It?

Even if it’s possible to engage in direct indexing at costs approaching those of traditional index fund fees, why not simply go along for the low-cost index fund ride? The potentials are two-fold:

More Flexible Tax Management: If you invest in index mutual funds or ETFs, you can only incur gains/losses on the fund’s share price. With direct indexing, you can trade on each underlying security you hold. For your taxable accounts, direct indexing thus offers more flexibility to manage when and how to incur taxable gains and losses, with an eye toward reducing your lifetime tax liabilities.

More Personalized Experience: Direct indexing also offers more flexibility to start with a popular index, and add exceptions based on your personal financial goals. For example, you could use direct indexing to augment a regular indexing approach with a personalized values-based filter (such as adjusting your mix of “virtuous” vs. “sin” stocks). Or, if you’re employed in a hot sector such as technology, you might reduce some of your exposure to that sector, to offset the concentrated risks you’re already incurring through your career.

Is It Worth It?

Direct indexing may offer more granular portfolio and tax management than you can get through traditional index fund investing. But any incremental benefits must be weighed against the tradeoffs involved in implementing them. We also must determine not only whether direct indexing may be an acceptable solution, but whether it’s the best one available.

On both counts, we’re not as enthused by direct indexing as we are by our current approach to helping investors achieve their long-term financial goals.

Our concerns can be captured in a word: stamina. Your ideal investment portfolio must not only start strong, it must be built to last.

What Is Your End Game?

Let’s start by taking a step back. Why invest to begin with?

We believe the best reason to invest is to create or preserve enough wealth to fund your future goals, even as inflation nibbles away at our money’s spending power over time. An additional, immediate reward comes from the tranquility you feel today, knowing you have a dependable financial safety net to protect yourself against tomorrow’s unknowns.

This leads to a critical understanding: You and your ideal investments must not only start out strong. They must have the stamina to last.

We’re not yet convinced direct indexing is the best solution for this essential duty. The complexities involved may make it harder rather than easier to build, manage, and stick with your ideal low-cost globally diversified investment portfolio, tailored to reflect your personal financial goals and risk tolerances.

Course Corrections

Effectively tracking an index over time isn’t as simple as it may sound. Like trying to walk across a swaying bridge on a spinning planet, everything is in constant motion. Managing all the movement (and reporting it on your tax returns) can leave you dizzy.

Reconstituting: The index you’re tracking periodically reconstitutes its holdings, removing companies that no longer best represent its target asset class, and adding ones that do. To continue tracking the index, you’ll need to shift your holdings as well.
Rebalancing: Markets move too. To sustain your investment allocations, you’ll periodically buy more of the recently underperforming assets and sell some of the recent winners.
Reallocating: Your own financial goals may also evolve over time, calling for a shift in your underlying allocations. This too requires additional trades, to stay on track with your goals.

Tax Entanglements

With traditional index investing, if you (or your advisor) harvest tax losses or incur taxable gains to rebalance or otherwise manage your portfolio, you’ll trade a few funds, and report the results on your annual return. To accomplish these same tasks with direct indexing, you or your service provider might need to place hundreds of trades, several times a year. Each trade becomes a line item you and your accountant must accurately track and report come tax time.

Active Temptations

What if you’re using direct indexing to make individual exceptions to a standard index fund or similar asset-class approach? This generates additional layers of complexity, which can make it harder to stay on course toward your desired destination.

If you’re no longer closely tracking indexes or similar standardized benchmarks, at what point do you lose control over understanding your portfolio-wide risks and expected returns?
How do you make sensible adjustments over time, without throwing your portfolio’s carefully structured asset allocations out of whack?
Will you succumb to tracking error regret, and lose your stamina if your portfolio underperforms its closest benchmark (even if it’s expected to)?
Why are you making the exceptions to begin with? If it’s to bring your total portfolio closer to its intended asset allocation, it might make sense. If you believe you know more than the market does about what lies ahead, you’re no longer investing; you’re speculating.

Operating Efficiencies

By building your portfolio using well-managed, low-cost index or similar asset-class funds, you’re essentially hiring a professional to manage many of these complexities for you. The complexities don’t necessarily go away, but most of them happen behind the scenes. Especially over time, this offers a cleaner view of where you’re at and where you’re headed, which can in turn make it easier to maintain your investment stamina.

A quality fund manager can also often add value to your experience. For example:

A fund manager’s economies of scale may offer them more leverage than you have as an individual investor. This can help them trade more patiently and cost-effectively when an index undergoes reconstitution, or market prices are swinging to extremes.
You can find global core funds that replicate a typical asset-allocated portfolio for you—including taking care of rebalancing it over time.
Some fund managers offer tax-managed versions of their funds.
These days, there are a growing number of solutions for those who would like to integrate sustainable, ESG (Environmental, Social, and Governance), or other values-based investing into their structured portfolios.

Simple, Sensible Success

Investment success comes from investing according to a plan that makes sense to you. It also should make sense for you, given your goals. It should increase your ability to build the wealth you need, while managing the risks involved. As important, it should be simple enough to stick with—basically forever.

At least on paper, direct indexing offers some of these qualities. But why try to dismember an efficient machine into its individual parts? For the vast majority of investors, we can deploy a simpler, cost-effective, funds-based approach to closely track your personal financial goals.

The medical profession relies on sound research from peer-reviewed medical journals. At Open Window, we follow a similar course. We adopt change as guided by research from leading academics and Nobel Laureates in Economic Science.

As our professional acquaintance and “Fortunes and Frictions” investment blogger Rubin Miller, CFA said in an investment lessons post:

“Successful investors architect successful outcomes. An often under-respected element of elite investing is that more effort typically leads to worse outcomes.
If you want to be an elite doctor or lawyer – wake up early, study hard, try to attend great schools. But if you want to be an elite equity investor, simply buy the global stock market for a low cost, and get out of the way.”

Please be in touch if you’d like to learn more about our disciplined, time-tested approach to portfolio management.

[1] As index investing has proliferated, so have more exotic indexes, tracking trends such as fine wine or Canadian cannabis. For our purposes, we are referring to traditional indexes, tracking broadly recognized market asset classes.

[2] One proponent of direct indexing suggests: “[Y]ou can capture the vast majority of diversification benefits of the S&P 500 by owning the largest 100 stocks in the S&P 500 Index.”