There’s a newly revived concept sweeping across the financial services industry, and you may have heard of it. It’s called Direct Indexing. I say it’s newly revived because it isn’t actually new – Direct Investing has been around for 30 years or so. We’re not talking about buying & holding an index fund like you may see inside your 401k plan at work. No, we’re talking about actively controlling a portfolio that very closely resembles a specific index, but is managed just for you.
Direct Indexing is an alternative to buying an index mutual fund or exchange-traded fund (ETF) and has many features that differentiate it from index funds. That’s part of the reason this concept is so popular with both investors and advisors. Many big-name financial companies have added Direct Indexing to their offerings in the past few years, including the likes of JPMorgan, Natixis, Morgan Stanley, Blackrock, Franklin Templeton, Charles Schwab, and many more.
In this article, we’ll explore this concept and discuss how our financial advisors can help you decide if it’s a good fit for you.
What Is Direct Indexing?
The main difference between Direct Indexing and owning an index fund is that with Direct Indexing the investor owns the securities that represent the index directly, hence the name. That makes all the difference because these portfolios can be customized to meet each individual investor’s needs, as opposed to the index fund investor who owns the same exact thing as all other investors in that same index fund. To get started, an investor identifies a market index they want to invest in. Then parameters are set for how the index will be managed. While the portfolio will resemble the chosen index, there can be some major differences.
Customization can include which indexes to utilize; how taxable gains and losses are handled; exclusion of certain securities or sectors; Environmental, Social, and Governance (ESG) investing and other socially responsible criteria; geographic preferences; and trading frequency, among many other criteria.
Advances in technology have made all this customization possible. Modern trading platforms enable optimization for tax-loss harvesting, use of multiple indexes, trading and rebalancing, and much more. Technology has helped to achieve efficiencies at the Direct Indexing providers, and that has led to reduced fees and account size minimums. No longer is this only for the wealthy crowd!
What Are the Benefits of Direct Indexing?
Many investors choose Direct Indexing since it offers several advantages. The following are some reasons to consider this investment method:
In any given year, some securities in an index go up and some go down. Direct Indexing gives the investor the ability to capture gains and losses on individual securities in an index throughout the year. That can be very powerful, because paying untimely taxes on gains can drag down performance. Index funds not only don’t allow for that control, but they subject each investor to the consequences of all other investors’ buying and selling behavior throughout the year. The result can be, and sometimes is, paying taxes on gains in a year that the index goes down in value. Talk about pouring salt in an open wound!
Some Direct Indexing providers allow investors to set limits on how much capital gains and losses they want to target for a given year. Losses may even be captured in years in which the index goes up in value. Realized tax losses can be used against other income in the current year, as well as in future years.
To illustrate the concept, think back to 2020. Overall, it was a good year in the stock markets, despite what was going on in the world. The S&P 500 index gained about 18% for the year, but it was a volatile year along the way. Of the 500 stocks in the index, 196 S&P 500 stocks had losses for 2020. Direct Indexing allows investors to access those losses during the year, to potentially offset other gains elsewhere. Index funds do not allow for that possibility.
Account Minimums Are Coming Down
With more major asset managers entering the field, account minimums and management fees have been coming down. Competition has increased, and that benefits the investor. While many firms used to require $100,000 to $250,000 to utilize Direct Indexing, nowadays we are seeing options opening up to accounts with $50,000 to $75,000.
The advent of algorithmic trading, fractional share ownership, zero commission trading, and AI has helped firms scale their offerings more efficiently, so perhaps this trend may continue.
Transparency and Control
Direct Indexing account owners will not only be able to see all their individual securities but will also be able to control buying and selling of those securities as each year progresses. These platforms offer more opportunities for tax-loss harvesting because there are simply more securities to manage.
Who Is a Good Fit for Direct Indexing?
The most obvious answer is an investor looking to control taxable gains and losses. High tax bracket individuals may be especially interested, as active tax management can help reduce their tax bill in some years. Direct Indexing, however, is also a good fit for long-term investors seeking customization, transparency, or management of concentrated stock positions.
As mentioned above, the door is now open to smaller accounts and a wider range of investors. Accounts can be funded with cash or existing securities, so individuals with existing portfolios don’t have to liquidate an entire account to utilize Direct Indexing.
If you’re not sure if you are a good candidate for Direct Indexing, just contact us to find out.
We Can Help You Decide If Direct Indexing Is Right for You
Although Direct Indexing is not new, it is evolving. More firms are entering the space, and competition continues to enhance how accounts are managed and what benefits are available to investors. Our advisors at HighPoint Advisors, LLC, can help make sense of this complicated landscape. We’re here to give advice on any aspect of portfolios and wealth management.
Our firm is fully independent and unbiased, so all we care about is what is right for our clients. We have unique insights into this space, and work with many providers that offer a range of Direct Indexing services.
Contact us today so our financial advisors can determine if this is a good fit for you!