What is Direct Indexing?

by | Sep 16, 2022 | Research

Direct indexing offers a fresh perspective on traditional index investment strategies. This method involves owning the underlying securities in a benchmark, rather than purchasing products like index mutual funds or ETFs.

Over the next five years, investments in direct indexing are projected to grow more quickly than investments in traditional financial products like mutual funds and ETFs. A direct indexing strategy can involve significantly more effort than buying a mutual fund or an ETF, so why bother? To fully understand the answer to this question, you must first understand the details of how direct indexing works and the benefits this strategy provides.

What is Direct Indexing?

Direct indexing is an investment strategy which involves purchasing the individual securities that comprise an index rather than using a mutual fund or ETF to track a benchmark. For example, an investor could purchase some or all the stocks in the S&P 500 rather than purchasing a mutual fund which tracks that index.

Direct Indexing:an investment strategy which involves purchasing the individual securities that comprise an index rather than using a mutual fund or ETF to track a benchmark

In the past, high transaction costs were a significant roadblock to implementing direct indexing, which made index funds and ETFs more cost effective. In the last decade, however, the major investment companies have greatly reduced or eliminated commissions on stock trades. These lower costs mean direct indexing can now be a viable strategy for the average investor.

Benefits of Direct Indexing

Direct indexing allows you to achieve additional portfolio customization while reducing or eliminating fees typically associated with mutual funds. In addition, direct indexing provides tax benefits that are unavailable with other investing strategies.

Direct Indexing Allows for More Customization than Traditional Financial Products

With an index mutual fund or ETF, you have little control over which companies are included in the fund or how much of each security you own. On the other hand, a direct indexing strategy allows more flexibility for your investments.

Because you are building a custom portfolio, you are not required to own all the securities included in the benchmark index or maintain their relative weights. In fact, a direct indexing strategy leaves room to track the general performance of a benchmark, while excluding certain disadvantaged companies or buying more of those you prefer.

Direct Indexing Allows for “Tilts” Toward Specific Sectors and Strategies

As the name suggests, a portfolio with a “tilt” is designed to be overweight in a particular company or industry when compared to the benchmark. For example, a portfolio could mimic the S&P 500 with a “tilt” toward technology companies. If the tech sector were to outperform the rest of the index, the tilted portfolio would also outperform the index.

While direct indexing generally seeks to create a portfolio that mirrors a benchmark index, it doesn’t have to be exact. Since you control your investments, you can eliminate companies that don’t match your investing strategy or your convictions. For example, your portfolio could be designed to follow the Nasdaq Composite index but exclude organizations that do not perform well on Environmental, Social, and Governance [ESG] principals.

Direct Indexing Could Generate Superior Tax Benefits Compared to Traditional Financial Products

Those who implement direct indexing can take advantage of tax loss harvesting. This strategy involves selling poor performing stocks to generate losses that offset gains for tax purposes. Under current law, individuals can use investment losses to offset the amount of capital gains tax due on the profits from the sale of other securities. When implemented in a portfolio of individual stocks, tax loss harvesting is estimated to create an additional 1.08% in after-tax returns.

Many investment strategies do not allow investors to tax loss harvest effectively. Mutual funds are prevented from passing individual security losses to shareholders and most ETFs are not designed for tax loss harvesting. For this reason, owning the underlying securities is often a better method for minimizing taxes than investing in traditional products like mutual funds or ETFs.

Direct Indexing Can Reduce Hidden Investment Fees

Hidden fees are unfortunately common in the finance industry, and they reduce investment returns. In particular, mutual funds can carry expensive front-end and back-end loads. With direct indexing, investors aren’t subject to fees outside of the transaction costs for buying securities. This means you can avoid many of the most common hidden investment fees with a direct indexing strategy.

How to Implement Direct Indexing

Not all investment firms or financial advisors offer direct indexing, and the main reason is the strategy requires a great deal of effort and knowledge to be effective. Rather than making one simple transaction to buy a mutual fund or an ETF, an advisor would need to effectively design a portfolio that meets their client’s needs and buy all the individual stocks.

If you are interested in exploring a direct indexing strategy, you should first locate a financial advisor who can build a custom portfolio. In fact, only the most experienced advisors should manage a direct indexing strategy, so be sure to find an advisor who has experience in this area to guide you.

When choosing a financial advisor to implement direct indexing, it’s also important to seek a fiduciary. Fiduciary advisors are obligated to act in their clients’ best interests – all the time, so you can feel confident knowing that your advisor’s recommendations are made without conflicts of interest.

By partnering with an experienced, fiduciary wealth manager to implement direct indexing, you can take advantage of the benefits of index investing while maintaining complete control of your portfolio. Then you can rest assured that you are investing according to your values and interests while gaining tax advantages and growing your savings.

Direct Indexing with DreamWork Financial Group

In the past, customized portfolios have been available only to the very wealthy, but with Investing Gameplan™ by DreamWork Financial Group, You Don’t Have to Be Wealthy to Have Wealth Management®.  Investing Gameplan™ is a truly unique wealth management program that allows all investors, no matter their net worth, to access innovative wealth management strategies like direct indexing.

Our fiduciary advisors can create a custom portfolio for you while cultivating a financial partnership where your input is valued. To learn more about direct indexing with Investing Gameplan™, contact us today.

Article Topics: Investment Advice | Investments