Direct indexing may soon become more widely available. What there is to know


Direct indexing, which allows investors to buy stocks in an index, instead of buying a mutual or exchange-traded fund, may soon be available to more investors.

While the very wealthy have historically used this strategy, those with fewer assets may soon have access to it as more financial services companies use these solutions.

For example, Vanguard last month acquired Just Invest, a direct indexing company. BlackRock has also made investments, acquiring Aperio in 2020 and recently purchasing a minor stake in SpiderRock Advisors.

Additionally, Morgan Stanley joined the game last year by acquiring Eaton Vance, parent company of the Parametric custom indexer.

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“People want a little more control over what they invest in,” said Michael Whitman, chartered financial planner, managing partner of Millennium Planning in Pittsboro, North Carolina. “And when you buy into a mutual fund or an ETF, you are at the mercy of the manager.”

Here’s how it works: After choosing an index to track, financial advisers buy a representative share of the stocks in the index and manage those assets by rebalancing the portfolio over time. These holdings are usually in a taxable brokerage account.

Direct indexing generally works best for larger portfolios, as it can be expensive to own a full index. However, this hurdle may shift as more brokers offer so-called split trades, allowing investors to buy partial shares.

“You have to have at least $ 80,000 to $ 100,000 for this to make sense,” Whitman added.

For example, an advisor can buy 150 to 200 stocks to track the S&P 500, said Ken Nuttall, CFP and chief investment officer at BlackDiamond Wealth in West Grove, Pennsylvania.

“The beauty is that not all stocks go up,” he said. As some go down, advisers may sell certain stocks at a loss to help offset overall portfolio gains, a tactic called tax-loss harvesting. Advisors can rebalance monthly, quarterly, or more often during volatile times.

Almost half of actively managed accounts do not receive any tax treatment, according to a Cerulli report. However, financial experts claim that direct indexing can deliver what’s known as tax alpha, which delivers higher returns through tax saving techniques.

However, since direct indexing is an active strategy, it is more expensive than owning passively managed assets, such as index funds and ETFs.

While the average fee for passive funds is 0.13%, in 2019, according to Morningstar, the cost of direct indexing could be closer to 0.30% to 0.40%, Whitman said.

Still, the expense may be worth it for those seeking more flexibility and tax savings, especially with the looming threat of capital gains tax hikes proposed by President Joe Biden.

Portfolio customization

Direct indexing may also be of interest to those seeking greater portfolio customization, such as value investors who wish to divest from specific sectors, said Charles Sachs, CFP and chief investment officer at Kaufman Rossin Wealth in Miami.

“It’s a great way to be able to direct your portfolios to causes you believe in,” he said.

Customizing the portfolio can also be useful for someone who owns many stocks of the same stock.

It’s a great way to be able to direct your portfolios to causes you believe in.

Charles Sachs

Director of Investments at Kaufman Rossin Wealth

For example, an Apple or Amazon executive may want to diversify by investing in an index without their company’s holdings. Direct indexing can allow them to choose their stocks, he said.

While direct indexing may appeal to those looking for more control, experts say it may be too difficult for independent investors.

“It’s almost impossible to go into a brokerage account and buy 100 to 150 stocks and know what you’re doing,” Whitman said. Those considering the strategy should discuss the pros and cons with a trusted financial advisor.

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