Index funds and exchange traded funds (ETFs) have revolutionized investing by driving costs down, while expanding investor access to different segments of the market. But there's historically been a catch with index investing: investors have little to no control over the individual holdings within the fund.
No longer. Direct indexing, once confined to institutional and high-net-worth investors, is now available to a broader array of investors thanks to technological advances that have brought investment minimums down. Whereas traditional indexing attempts to replicate the performance of an index via an ETF or indexed mutual fund, direct indexing mimics the performance of an index by directly holding select securities within the index. This feature enables investors to customize specific holdings to suit their needs, while it also provides opportunities to harvest tax losses at the individual security level to offset capital gains and boost after-tax returns.
In this way, direct indexing is part of the latest wave of innovation – such as advances like commission-free trading and fractional shares – that is giving investors more choices and control. "Allowing for personalization makes direct indexing a great fit for those who generally like low-cost passive strategies but are also looking to potentially outperform the index on both before-tax and after-tax basis, or have more flexibility in terms of what they own," says Nitin Barve, CFA®, Director of Portfolio Analysis and Advice Tools & Policy at the Schwab Center for Financial Research.
Is direct indexing right for you? Here are three questions to consider.
Do you want to be able to customize your holdings?
Index funds and ETFs generally strive to match the returns of their benchmark index, in order to keep their costs down. This means investments in those funds generally closely mirror the exposure to various same securities in the index, with no deviation allowed. In other words, these products very closely track the return and risk characteristics of the underlying index.
That can be a problem for investors who want to own a fund but have an oversized position in a member of the index. They might be overconcentrated in the stock of their employer, for instance. Alternately, they might take issue with one company in an index because the business doesn't align with their personal values or beliefs, or they don't like its future prospects. Or they might feel like a certain sector is primed to do better than others and want to tactically increase their exposure to it by investing in a direct index offering that's weighted in that sector.
Direct indexing fits these needs by offering the ability to remove or replace select securities from an index, much like adding or subtracting toppings from their favorite pizza. This customization is typically handled by the fund manager through a separately managed account and is usually limited to a few substitutions at the outset. But the ability to adjust even a few holdings can open the door to an investor owning a fund they otherwise would not find suitable.
Would you rather try to outperform the market or simply match it?
For some investors, replicating the return of the market or a specific index is just fine, particularly when prices are generally rising. But others might want more without taking on too much additional risk, and that's where the tax optimization enabled by direct indexing can make a difference.
Portfolio managers who offer direct indexing are not trying to beat the market (on a before-tax basis) by actively picking stocks to buy or sell based on fundamental or technical analysis. Instead, they're focused on generating better after-tax returns by selectively taking advantage of tax-loss harvesting opportunities. Securities that have losses are sold in order to offset gains in the winning positions—something a regular index fund or ETF can't do because the index securities are owned as a group by the fund sponsor and not by individual investors.
Even seemingly modest differences between after-tax and before-tax returns can add up over time due to the benefits of compounding. Research shows that an optimal tax-loss harvesting strategy can yield tax-enhanced returns (i.e., "tax alpha") of as much as 1.1 percent per year, and that such gains can lead a tax-aware portfolio to outperform a similar buy-and-hold portfolio by a total of 27 percent over a 25-year period.
Investors capable of taking advantage of direct indexing solutions tend to have higher income-tax rates due to their relatively high minimum investment thresholds, meaning they enjoy greater potential to generate tax alpha. Those who live in high-income-tax states such as California and New York also may have more to gain from the potential tax savings. Of course, the investments need to be held in a taxable account to be able to take full advantage of this benefit. And the compounding benefits of the tax savings tend to accrue to those who have a long-term buy-and-hold investment strategy for a sizable portion of their assets.
It's also worth noting that deviating from the underlying index could expose you to some tracking error – the difference between the return investors receive and that of the benchmark they're trying to mimic – as well as the risk of underperformance. Some firms seek to mitigate this risk by offering built-in rebalancing based on pre-established thresholds. But the higher risk/return tradeoff is worth considering when examining whether direct indexing is right for you.
Are you worried about emotions affecting your buy and sell decisions?
Let's face it – emotions can get the best of any investor. Index funds and ETFs can be a good antidote to emotion-charged investing by putting investments on autopilot. But, as discussed above, passive investments can be limiting. Actively managed funds continue to attract a significant amount of investor capital each year because they offload market timing and other decisions to professional money managers. Of course, this benefit comes at a higher cost.
Direct indexing marries both approaches. While giving you more control over what the index holds at the outset, the day-to-day management is left up to the portfolio managers. They monitor the holdings on an ongoing basis and retain full discretion over the account, deciding what to sell and when. Because their choices are limited to tax-loss harvesting opportunities, that helps keep their management fee lower than those charged by traditional actively managed funds.
"Direct indexing offers some of the characteristics of active management, including the ability to weather particularly challenging episodes in the market when our emotions tend to get the best of us, as investors are often reluctant to sell positions with losses even though they can generate tax-loss harvesting opportunities" Nitin says. "And you get those features at a fraction of the normal cost."
Getting what you pay for
Given that direct indexing costs may be higher than traditional index funds or ETFs, you'll want to be sure the features of direct indexing listed above fit your objectives. If they do, then direct indexing can be a great supplement to other investing strategies already working well for you in your portfolio.
What you can do next
Want to get started with Direct Indexing? Learn about Schwab Personalized IndexingTM
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Neither the tax-loss harvesting strategy nor any discussion herein is intended as tax advice, and does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks including unintended tax implications. Investors should consult with their tax advisors and refer to Internal Revenue Service ("IRS") website at www.irs.gov about the consequences of tax-loss harvesting.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when a non‐retirement account is rebalanced, taxable events may be created that may affect your tax liability.
Investing involves risks including loss of principal.0722-25LL