If there has been one overarching theme that has dominated Wall Street for the last decade, it has to be falling fees. Costs for pretty much everything investment-related have continued to drop since the end of the Great Recession. Thanks to gains in technology, indexing, and competition, investors are simply paying less to buy/sell investments, own them for a period of time, and pay for advice. And the latest trend to hit the street is the culmination of these lower costs.
We’re talking about direct indexing.
With free brokerage commissions, fractional shares, and automated portfolio management, the idea of owning an index directly rather than via a fund is a reality. And there are plenty of benefits that come with that potential.
For passive and active ETF holders or sponsors, direct indexing could be the next wave of investment management and bring forth plenty of changes.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
Direct Indexing In a Nutshell
If you want to buy the S&P 500, the easiest way has been to buy shares of a fund or ETF like the SPDR S&P 500 ETF Trust (SPY) that owns all the stocks in the index. Funds and ETFs work by pooling a bunch of investors’ capital and buying shares together. The same could be said for actively managed funds.
Replicating the S&P 500 on your own, however, is a daunting task. You would have to buy all the stocks in the index in proportion to the investment amount. You’d have to pay brokerage commissions on all those trades and would need a very large sum of starting capital to do it right. Even for institutional investors, this isn’t an easy task and it’s why many of them still use ETFs or mutual funds. It’s quick and painless.
Nevertheless, those difficulties could be waning. Welcome to the world of direct indexing.
In direct indexing, investors literally buy all the stocks in an index and in the same weights as the benchmark. Thanks to the world of zero commissions on stock trades, the concept is now possible. Investors can now buy 500 or 1000 different stocks and pay literally nothing to do so. Even better is the fractional share programs that many brokerages have started offering allow investors to own pieces of a stock. To replicate an index, an investor doesn’t have to own whole shares in the same weighting of a benchmark. In theory, you can take $100 and buy all the shares of the S&P 500 fractionally.
The Benefits of Direct Indexing
So why would investors want to do this instead of just owning the SPY or a similar indexed vehicle? Two words: Uncle Sam.
The real benefit of direct indexing comes down to the ability to manage taxes. One of the most successful tax mitigation techniques that investors can use is called tax-loss harvesting. This involves selling loss-making stocks to cover the tax gains on winning positions. With ETFs or mutual funds, investors can’t harvest tax losses on the individual positions within the fund. But, if you own the positions outright, you can prune losers and let the winners run.
And investors may want to do just that. A Chapman University study showed that from 1926 to 2018, investors could improve their after-tax returns by 1.08% annually by using a tax-loss harvesting strategy and buying the S&P 500 each month.
Direct Indexing can also allow for customization. Investors and advisors can create their own benchmarks and indexes or remove certain segments from popular indices. Here, active and passive management are blended. Investors can also remove conflicts as well. If you’re an Apple employee and already own a ton of Apple (AAPL) stock in your workplace plan or direct-stock purchase plan, having more of it in your portfolio may not be a good thing. Direct indexing can be used to skip AAPL in other portions of your holdings.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
Coming to a Brokerage Near You
So, how serious is Wall Street about direct indexing? Very serious, it turns out.
A variety of investment managers have started to make moves into the concept. Indexing pioneer Vanguard recently acquired direct indexing company Just Invest, BlackRock purchased Aperio and SpiderRock Advisors, while Morgan Stanley (owner of brokerage E*TRADE) recently purchased Eaton Vance and its custom indexer Parametric.
With that, direct indexing could be an option for many investors sooner rather than later.
However, there are some cons with the strategy. One is that the starting capital needed is high. To truly benefit from tax-loss harvesting, many analysts suggest that a portfolio be around $80k to $100k. Lower than that and the overall benefit is muted.
Secondly, for tax-harvesting to work, you need to be wary of wash-sale rules. That means you can’t own the entire index at one time. A direct index strategy needs 150 to 200 stocks of an index that can replicate the return. That way, you can sell the losers and buy the winners.
Finally, tax-loss harvesting only works in a taxable account. Most investors have their nest eggs located in tax-deferred or tax-free retirement accounts. So, there is no point in using the technique. Owning an index fund is still the best option.
Regardless, direct indexing is now a viable option for many investors. As such, it could give traditional passive investing, smart-beta, and active strategies a run for their money.
Don’t forget to explore our Dividend Guide where you can access all the relevant content and tools available on Dividend.com based on your unique requirements.
