As demand grows for specialized portfolios, a trend known as direct indexing is quickly becoming an option for more investors.
Rather than owning a mutual or exchange-traded fund, direct indexing is buying the stocks of an index to achieve goals like tax efficiency, diversification or values-based investing.
Traditionally used by institutional and high-net worth investors, direct indexing is poised to grow more than 12% per year, faster than estimates for mutual funds and ETFs, according to Cerulli Associates.
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Companies like Morgan Stanley, BlackRock, JPMorgan Chase, Vanguard, Franklin Templeton, Charles Schwab and Fidelity have already entered the space, betting on broader access.
“It says a lot that these large fund providers are leaning into direct indexing,” said Adam Grealish, head of investments at Altruist, an advisor platform with a direct indexing product.
How direct indexing works
Charles Sachs, a certified financial planner and chief investment officer at Kaufman Rossin Wealth in Miami, said one of the biggest perks of direct indexing is flexibility.
Here’s how it works: Financial advisors buy a representative share of an index’s stocks and rebalance over time, typically in a taxable brokerage account.
Direct indexing generally works best for bigger portfolios because it may be costly to own an entire index. However, this barrier is shrinking as more brokers offer so-called fractional trading, allowing investors to buy partial shares.
Boost portfolio returns through tax-loss harvesting
One of the biggest perks of direct indexing is so-called tax-loss harvesting, enabling investors to offset profits with losses when the stock market drops.
More than half of actively-managed accounts don’t receive any tax treatment, according to a Cerulli report.
“Direct indexing offers more opportunities to tax-loss harvest because there are simply more individual stocks,” Grealish said.
Financial experts say direct indexing may offer so-called tax alpha, providing higher returns through tax-saving techniques.
Indeed, strategic tax-loss harvesting may boost portfolio returns by one percentage point or more, according to research from Vanguard, which may be significant over time.
Easier to customize your portfolio
Direct indexing may also appeal to those looking for portfolio customization, such as value-based investors who want to divest from specific sectors.
“Everyone’s values are slightly different,” said Grealish. “So a fund is rarely the best way to get pinpoint accuracy in expressing your values.”
Customization may also be handy for someone with many shares of a single stock who wants to diversify their portfolio.
However, direct indexing may have higher costs and more complexity than buying a passively-managed index fund, Sachs said.
Direct indexing becoming ‘democratized’
Although the concept has been around for decades, it’s becoming more accessible as major asset managers enter the space and fees and account minimums drop.
“It’s kind of being democratized,” said Pete Dietrich, head of wealth indexes at Morningstar.
While platforms with tax features and values-based investing customization may have cost around 0.35% a year and a half ago, you may see similar platforms around 0.3%, 0.2% or even lower today, Dietrich said.
By comparison, the average expense ratio for passively managed funds was 0.12% in 2020, according to Morningstar.
“I think you’re starting to see around $150,000 to $250,000 account minimums, coming down very quickly to $75,000,” he said, noting some platforms are even lower, depending on platform capability.