• AllisonDunlap

Direct Indexing - Is It Right for Your Portfolio?

Updated: Feb 20, 2020

Investing is always evolving. In the early '90s, the biggest innovation in finance was the ETF, or exchange-traded fund, which allowed investors to buy into a pool of hundreds of securities with a single trade. One type of ETF that has become increasingly popular is the “index ETF”, which offers a one-stop-shop for exposure to the stock market through the index it tracks. The latest buzzword in investing is “direct indexing” – but is this an exciting new investment strategy or just something to add to the ole’ sales pitch for advisers?

First, let’s start with what it is. Direct indexing means owning all of the stocks comprising an index individually, allowing you to bypass the fund structure altogether. For example, instead of buying the Vanguard S&P 500 ETF for exposure to large cap equities, you would buy each individual stock in the same proportions as in the S&P 500 index and re-balance over time. Sounds complex and labor intensive, right?

While the concept of direct indexing is not new, more advanced digital investing platforms and fractional share trading have made this method of investing feasible and more accessible to a broader range of investors. Also, now that certain custodians like Fidelity and Schwab offer commission-free equity trading, it is much more economical to invest in an index directly. But why would you do this?

The following are some potential benefits of direct indexing:

· Strategy options – You can choose from any number of benchmarks, such as the Russell 2000, or index ETFs, such as Invesco QQQ.

· Tax loss harvesting – Direct indexing offers more control over gains and losses throughout the year. The portfolio manager for your direct indexing strategy can opportunistically sell individual stocks at a loss to offset capital gains while staying true to the risk/return profile of the desired benchmark. Conversely, the entire position in an index ETF or mutual fund would have to be sold to harvest losses. Direct indexing also avoids the capital gains distributions inherent in mutual funds and, to a lesser extent, ETFs.

· Customization – An investor can customize the portfolio according to broad-based environmental, social and governance (“ESG”) filters, such as eliminating weapons manufacturers or companies with high carbon emissions. You can also exclude individual equities, for example, excluding Facebook because you work there and have employee stock ownership or because you dislike fake news, inspirational quotes and political rants.

If you are intrigued by the potential tax and/or customization benefits of this strategy, you also should consider the following:

· Investment location - This strategy is best used in a taxable brokerage account where you can take advantage of tax loss harvesting.

· Size matters - Creating an index fund such as the Nasdaq 100 means investing in 100 of the largest non-financial companies listed on the Nasdaq stock market. It wouldn’t make sense to do this with a $1,000 or even a $10,000 allocation.

· Cost comparison - Do the tax-loss harvesting benefits outweigh the cost of direct indexing versus a low-cost index ETF?

· Active vs. passive investing - If you make too many changes to an index, you are straying into the territory of active management and likely increasing the tracking error relative to the underlying index.

In conclusion, if you have a large taxable brokerage account, are in a high tax bracket, and have strong convictions about something like climate change, direct indexing might be worth looking into. This is an investment offering that I have been researching and will begin making available to clients this year, so feel free to contact me if you’d like to learn more.

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