Understanding Direct Indexing

6 mins read

Direct Indexing Meaning

Direct indexing is a kind of index investing in which the individual stocks that make up an index are purchased in the same weights as the index. Buying an index mutual fund or exchange-traded fund (ETF) that tracks the index is not the same thing.

Buying all of the stocks required to duplicate an index, particularly a large index like the S&P 500, used to necessitate dozens to hundreds of transactions, which may soon become prohibitively expensive in terms of commissions and costs. This problem has mostly vanished since the introduction of zero-commission stock trading on various internet brokerage platforms.

Nonetheless, because direct indexing necessitates an investor knowing exactly how many shares of each index component to buy and reweighting accordingly from time to time, a number of financial firms now provide automated direct indexing services for individual investors.

Understanding Direct Indexing

Direct indexing made sense mainly for large investors until recently, and it was often more expensive to adopt and maintain than holding an index fund. Index investors are increasingly interested in gaining control and autonomy in their portfolios, self-replicating indexes that were previously only viable and cost-effective via index mutual funds or index ETFs, since stock trading fees have essentially gone to nil. Furthermore, with fractional shares becoming more widely available, it is now easier than ever to duplicate a huge index with small amounts of investable assets.

Direct indexing decreases tracking error, or the difference in returns experienced by an index fund compared to its benchmark index, in addition to giving it more autonomy. The fact that many index funds and ETFs do not own the exact index, but rather approximate it in order to cut their own expenses, causes tracking inaccuracy, which can erode net gains. Management fees, taxes, and rebalancing time, among other things, can generate a mismatch even if a fund fully mimics an index. Every stock is held at the right weight with direct indexing.

Direct indexing, on the other hand, allows investors to tweak their portfolios in relation to the index weightings to significantly overweight or underweight certain assets or sectors, resulting in a “tilt.” For example, an investor’s portfolio could be skewed by holding 2% more tech companies and 2% fewer utility stocks than the index. The theory behind the so-called smart beta investment is based on this premise. Direct indexing helps investors to be more nimble and in charge of their portfolios.

Investing in a Passive Index

Index investing has grown to more than $4.3 trillion in assets as of 2021 and it is generally hailed as the finest or ideal investment approach for most long-term investors since Vanguard created the first mutual fund in 1976. The theory behind index investing is that markets are mostly efficient in general and over long time horizons, and hence there is no systematic way to consistently “beat the market” and gain excess profits. As a result, holding an index gives a well-diversified and representative portfolio. Indeed, multiple studies show that most actively managed investment strategies regularly underperform their benchmark, even when fees and taxes are factored in.

Buying shares of a broad-based index mutual fund or index ETF has traditionally been the easiest and most cost-effective option for investors to participate in a passive indexing approach. The managers of these funds try to mimic the benchmark index that the fund follows (such as the S&P 500 index) by owning the index’s component shares in the same weights as the index. Because the composition of an index does not vary frequently, these funds can charge relatively low management costs, which have been progressively reducing over time.

What Are Direct Indexing’s Advantages?

You are ultimately the portfolio manager when you own the equities directly. As a result, if you want to, you can change the index. Are there any stocks in the index that don’t match with your beliefs, such as in terms of environmental, social, or governance? You can sell them or avoid them using direct indexing. One thing to keep in mind: if your version of the index begins to diverge significantly from the “actual” index in terms of sector weightings and other factors, the performance will not match. This is referred to as a tracking error.

Direct indexing tailors an index to match an investor’s individual circumstances, optimizing for things like taxes, ESG exposure, or factor exposure. Where this leads an investor is a completely different place from where they started, which was a broad-based, market-cap-weighted index.

However, because it has been tailored to their tastes, it will eventually take the form of a distinct managed account. How they get from that starting point to that personalized portfolio is increasingly through some sort of software programme that incorporates all of the data related to taxes, tax preferences, and tax lots, as well as ESG criteria, factor exposures, and so on.

What Are the Characteristics of Direct Indexing?

Direct indexing is basically appropriate for people who have a lot of money to invest and want a lot of control over their investments. The selling technique itself is risky; perhaps holding on to the falling stock would have been a wiser long-term decision?

Then there’s the issue of taxes. It has no bearing on you if a fund buys and sells stocks. Only when you sell your units are you taxed. It will have a tax impact in this case. Furthermore, portfolio customization can become extremely difficult very rapidly. The ability to tailor your portfolio based on ESG or factor exposure may be enticing, but keeping track of all the shifting data points on 500 different securities can be overwhelming.

You’d also have to maintain track of index changes, such as rebalances and reconstitutions, to make sure you know which securities are added and deleted. For an annual fee, traditional index funds and exchange-traded funds will accomplish this for you.

Finally, keep an eye out for trade costs. Keep in mind that index-tracking strategies have a low turnover rate, which means they don’t buy and sell a lot of stocks. The more you trade and customize positions in a direct indexing portfolio, the more likely you are to incur transaction costs, which will reduce your overall return.

Wrapping Up

Investors and advisers can use direct indexing to create a portfolio that is distinct from the overall market or a broad-based index fund. While this may produce superior risk-adjusted returns over time, it often leads to lower returns for active managers.

Direct indexing essentially turns a huge number of investors into active managers. And what we know about active management, about being different from the market, is that it will seem correct sometimes and feel good, and it will look wrong and feel horrible at other times. In some cases, investors may be better served by just owning broad-based index mutual funds or discretionary active funds, as they would have obtained higher returns with less risk.