Investing in a fund that tracks a broad market index—such as an exchange-traded fund (ETF) or a mutual fund—is a simple, cost-effective way to participate in the market. That said, the average investor has been powerless to adjust an index's underlying holdings to reflect their individual circumstances or goals—until now.
Enter personalized indexing, which adds a degree of customization to the broad market exposure of index investing. Here's how it works.
Traditional index investing means buying a passive fund that seeks to track, rather than outperform, its benchmark index. Direct indexing, in contrast, involves buying most (if not all) of the individual stocks that make up an index, and then adding to, subtracting from, or reweighting its components, depending on your investing and tax goals. This gives you more control over your investment.
As you can imagine, the cost of replicating all the securities in a benchmark index—to say nothing of the associated management and trading fees—would be cost prohibitive for most investors, which is why direct indexing was previously available only to ultra-high-net-worth investors. However, the rise of zero-commission trading, as well as advances in technology, have made it possible for investment firms—including Schwab—to offer direct indexing products at a much lower cost.
There are several key advantages to customizing an existing index:
- Potentially boost after-tax returns: When you invest in an index mutual fund, you're subject to regular taxable distributions—even if you don't sell any shares—because mutual funds are required to distribute to shareholders any capital gains that were realized as a result of selling their underlying holdings. When you directly own the individual securities of an index, you control when shares are sold and thus when capital gains (or losses) are incurred, allowing you to better manage your tax liability—particularly when you have significant gains that could trigger a hefty tax bill. In such cases, you can choose to strategically sell some of your losers to offset those gains, a strategy known as tax-loss harvesting.
- Help reduce concentration risk: If you own substantial shares in a company that also represents a significant portion of an index, adding that index to your portfolio could create a concentration risk. For example, let's say you own $10,000 of Apple stock and want to invest an additional $90,000 in an index fund that tracks the Schwab 1000®. In mid-May 2022, Apple made up roughly 5.8% of the Schwab 1000, meaning your Apple exposure would rise to 15.2%. Personalized indexing would allow you to exclude Apple and keep your exposure to that stock at 10% of your overall portfolio.
- Better align your portfolio with your values: With a traditional index fund, there's no way to avoid industries that may be at odds with your goals or personal beliefs, such as gambling or tobacco. You can opt for a socially conscious fund, of which there are many, but you still have no control over the individual companies in which it invests. With personalized indexing, you can make exclusions within certain parameters. At Schwab, for example, you can exclude up to three securities from any of three indexes
There are some trade-offs with investing this way, namely:
- Higher costs: Expect to pay a management fee of anywhere from 0.30% to 0.40% for a personalized indexing solution, versus 0.20%, on average, for a traditional index fund.
- Higher minimums: Unlike index funds, many of which can be purchased for less than $50 a share, you'll likely need tens if not hundreds of thousands of dollars to invest in a personalized index strategy.
- Administrative burden: The downside to owning hundreds of individual stocks is that each will have its own cost basis, dividends, and profit and loss, which could become burdensome at tax time. Investors may have to report each transaction individually on their tax returns if their brokerage firms do not provide consolidated 1099 tax statements, or if their tax-preparation software does not accurately read the statements.
Ultimately, personalized indexing makes the most sense for investors in high tax brackets who want to take advantage of tax-optimization opportunities, as well as experienced investors who want more customization than they can get from a traditional index fund.
Schwab Personalized Indexing™
An index-based portfolio customized by you.
Designed to be a core component of your investments, Schwab Personalized Indexing offers three strategies based on established equity indexes:
- Schwab 1000 Equity: Designed to provide access to the 1,000 largest U.S. companies, covering approximately 90% of total U.S. stock market capitalization.
- S&P SmallCap 600®: Seeks to track 600 small-cap companies as defined by S&P Dow Jones Indices.
- MSCI KLD 400 Social: Designed to provide exposure to companies with outstanding environmental, social, and governance (ESG) ratings and excludes companies whose performance has had negative social or environmental impacts.
You can personalize your chosen strategy by excluding up to three stocks from the underlying index.
Investors should carefully consider information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.
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.
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.
Neither the tax-loss harvesting strategy, nor any discussion herein is intended as tax advice, and Schwab Asset Management 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 the IRS website at irs.gov about the consequences of tax-loss harvesting.
Diversification, asset allocation, and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when a nonretirement account is rebalanced, taxable events may be created that may affect your tax liability.
Please refer to the Charles Schwab Investment Management, Inc. Disclosure Brochure for additional information.
Portfolio Management for Schwab Personalized Indexing is provided by Charles Schwab Investment Management, Inc., dba Schwab Asset Management, a registered investment advisor and an affiliate of Charles Schwab & Co., Inc. (Schwab). Both Schwab Asset Management and Schwab are separate entities and subsidiaries of The Charles Schwab Corporation.
There are risks associated with any investment approach, and each Schwab Personalized Indexing strategy and equity market segment has its own set of risks based on client strategy selection and further customization.
Environmental, social, and governance (ESG) strategies implemented by mutual funds, exchange-traded funds (ETFs), and separately managed accounts are currently subject to inconsistent industry definitions and standards for the measurement and evaluation of ESG factors; therefore, such factors may differ significantly across strategies. As a result, it may be difficult to compare ESG investment products. Further, some issuers may present their investment products as employing an ESG strategy but may overstate or inconsistently apply ESG factors. An investment product's ESG strategy may significantly influence its performance. Because securities may be included or excluded based on ESG factors rather than other investment methodologies, the product's performance may differ (either higher or lower) from the overall market or comparable products that do not have ESG strategies. Environmental ("E") factors can include climate change, pollution, waste, and how an issuer protects and/or conserves natural resources. Social ("S") factors can include how an issuer manages its relationships with individuals, such as its employees, shareholders, and customers, as well as its community. Governance ("G") factors can include how an issuer operates, such as its leadership composition, pay and incentive structures, internal controls, and the rights of equity and debt holders. Carefully review an investment product's prospectus or disclosure brochure to learn more about how it incorporates ESG factors into its investment strategy. Strategies that use screening to exclude certain investments may not be able to take advantage of the same opportunities or market trends as strategies that do not use screens. There can be no assurance that the strategies will achieve their desired outcomes. Each investing strategy brings with it its own set of unique risks and benefits.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. For more information on indexes please see schwab.com/indexdefinitions.
All corporate names are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security.0822-2W8P