Ever heard or direct indexing? It is supposedly the next big thing for investing in 2021. Let me tell you why that isn’t likely. Direct indexing arose from a shortcoming in the way Exchange Traded Funds (ETFs) work. Most ETFs mimic an investing benchmark like the S&P 500 or the Russell 2000. Their main selling point is the elimination of security selection by active portfolio managers and a reduction in fees. Despite their utility and broad acceptance, they contain at least one flaw; investors cannot employ the tax benefit of portfolio losses unless they sell the entire ETF.
Direct indexing is essentially a Separately Managed Account (SMA) that replicates the benchmark. Instead of buying shares in an ETF that holds the entire index, investors buy those stocks directly. Direct indexing supporters highlight two benefits. First is the ability to harvest individual losses to offset gains, which sponsors estimate could add up to an additional 1% to annual returns. The second benefit takes direct indexing one step further. Custom indexing allows an investor to add tweaks to the index, to build a tailored portfolio suited to their values, interests, or outlooks. Yet downsides are material.
Limited harvesting candidates
Tax management has been an attribute of SMAs since their inception, which includes realizing losses to offset realized gains elsewhere or gifting the lowest cost stocks to a charitable organization. The only new idea with direct indexing is the composition of the portfolio. The problem with relying on tax harvesting for consistently adding value is the limited pool from which to draw. Investors will eventually run out of tax losses to realize, limiting claims of additional annual benefit due to tax management.
Blurs the lines with active investing
Custom indexing, as described above, is active management by a new name. Do you want to eliminate companies that burn coal? Do you want to eliminate companies that rank poorly on ESG criteria? Do you want to add growing companies that are not yet part of the index? You can make those changes, but your index is then no longer an index. You are an active investor, the very thing the index exposure was seeking to avoid.
Direct indexing products cost 0.15% – 0.35% of assets, less than actively managed mutual funds, but 3.5x the price of the most heavily selected ETFs. Direct indexing has been made far more efficient through technology and $0 commission at most brokerages. Yet, each bit of customization adds friction to the management of your portfolio, which incurs costs. If it is offered free, the manager is making money somewhere else. Meanwhile, the index ETF offers a cost structure in alignment with simplicity and efficiency.
If you direct index the S&P 500, imagine your statement showing 500-line items and associated trading activity. But portfolios typically do not stop at one ETF. Most will hold at least 5-10. What will your statement look like when the position data reaches into the thousands? How lengthy will the year-end tax statements be? In an era where technology helps simplify, this moves in the opposite direction.