What Is Direct Indexing? How It Works, Benefits, and Downsides

What Is Direct Indexing?

Direct indexing is an approach to index investing that involves buying the individual stocks that make up an index, in the same weights as the index. This is in contrast to buying an index mutual fund or index exchange-traded fund (index ETF) that tracks the index.

In the past, buying all of the stocks needed to replicate an index, especially a large index such as the S&P 500, required dozens to hundreds of transactions, which quickly could become overly expensive in terms of commissions and fees. However, with the advent of zero-commission stock trading on several online brokerage platforms, this concern has largely gone away.

Still, because direct indexing requires an investor to know exactly how many shares of each index component to buy, and to reweight accordingly from time to time (especially when the makeup of an index changes), several financial companies now offer automated direct indexing services for individual investors.

Key Takeaways

  • Direct indexing is an index investing strategy that involves directly purchasing the components of an index at the appropriate weights.
  • Direct indexing can provide greater autonomy, control, and tax advantages to certain investors over owning an index mutual fund or an index exchange-traded fund (index ETF).
  • Once reserved for wealthy investors, the rise of zero-commission trading and fractional shares has made direct investing available to many smaller investors.
  • Because it can still be time-consuming to build an index one stock at a time, many brokers have begun offering direct indexing services to their customers.

Understanding Direct Indexing

Until recently, direct indexing made sense only for large investors and typically would be more costly to implement and maintain than owning an index fund. As stock trading fees have dropped to effectively zero, index investors are increasingly interested in taking some control and autonomy in their portfolios, self-replicating indexes that were previously only practical and cost-effective via index mutual funds or index ETFs. Additionally, with the increasing ubiquity of fractional shares, it is easier than ever to replicate even a large index with modest sums of investible funds.

Aside from greater autonomy, direct indexing reduces tracking error, or the differences in returns experienced by an index fund compared to its benchmark index. Tracking error can erode net returns and arises from the fact that many index mutual funds and index ETFs do not own the exact index, but rather approximate it to reduce their own costs. Even if a fund fully replicates an index, management fees, taxes, and rebalancing timing, among other factors, can cause a mismatch. With direct indexing, every stock is held at the appropriate weight.

That said, direct indexing also allows investors to modify their portfolio relative to the index weightings to slightly overweight or underweight certain holdings or sectors, creating what is known as a tilt. For example, an investor may tilt their portfolio by holding 2% more tech stocks than the index and 2% fewer utilities stocks. This concept is the idea behind so-called smart beta investing. Direct indexing allows investors to be more nimble and take control of such a strategy.

Passive Index Investing

Since Vanguard introduced the first mutual fund at the start of 1976, index investing as a whole has grown to accumulate more than $4.2 trillion in assets as of 2022, and it is often heralded as the best or optimal investment strategy for most long-term investors. The idea behind index investing is that markets, in general and over longtime horizons, are largely efficient, so there is no systematic way to “beat the market” and earn excess returns on a regular basis. Thus, owning an index provides a representative and well-diversified portfolio. Indeed, several studies show that most actively managed investment strategies fail to consistently beat their benchmark, especially after taking into account fees and taxes.

The easiest and most cost-effective way for investors to engage in a passive indexing strategy has traditionally been to buy shares of a broad-based index mutual fund or index ETF. These funds’ managers seek to replicate the benchmark index that the fund tracks (such as the S&P 500 index) by owning the component shares of the index in the same weights as the index itself. Since an index’s composition does not change often, these funds are able to charge quite low management fees, which have been also been decreasing steadily over the years. For example, as of 2021, the Schwab U.S. Broad Market ETF (SCHB), the iShares Core S&P 500 ETF (IVV), and the Vanguard S&P 500 ETF (VOO) all have an annual expense ratio of just 0.03%.

Practical Considerations for Direct Indexing

While direct indexing may sound alluring, given the autonomy and tracking error benefits that it can hold over index funds, it does have some drawbacks. First of all, it can be quite time-consuming to identify all the stocks in an index and compute how many shares you must own given the amount of money that you will be investing. For the S&P 500, for example, you will have to buy 500 different stocks, placing 500 individual orders to fully replicate the index. Even if this comes at practically zero cost in commissions, taking the time to place those orders sequentially can take a long time, which means that some index components will rise or fall in the interim as the index is being constructed piecemeal. Some stocks may also be quite illiquid, meaning that a small investor may not be able to buy them at favorable prices all the time.

When it is time to sell the index portfolio, the same concerns that arose when purchasing the index will once again emerge.

As a result, several financial firms have started to provide direct indexing services to their customers, effectively automating the process and greatly reducing those concerns. Indeed, the likes of Vanguard, BlackRock (BLK), and Morgan Stanley (MS) now all provide direct indexing for their clients for a modest fee (which may be larger than owning an index fund). Investors who want autonomy and control over their index portfolios, or who can gain tax advantages from direct indexing, may prefer this route.

Article Sources
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