As demand for specialized portfolios grows, a trend known as direct indexing is quickly becoming available to more investors.
Instead of owning a mutual or exchange-traded fund, direct indexing is the purchase of index shares to achieve goals such as tax efficiency, diversification, or value-based investing.
Direct indexation, traditionally used by institutional and high net worth investors, is projected to grow at more than 12% per year, faster than mutual fund and ETF estimates. Cerulli Associates.
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Companies such as Morgan Stanley, BlackRock, JPMorgan Chase, Vanguard, Franklin Templeton, Charles Schwab and Fidelity have already entered the market betting on greater access.
“The fact that these big fund providers are leaning towards direct indexing speaks volumes,” said Adam Grealish, head of investment at Altruist, a direct indexing product advisory platform.
How direct indexing works
Charles Sachs, a certified financial planner and investment director at Kaufman Rossin Wealth in Miami, said one of the biggest benefits of direct indexing is flexibility.
Here’s how it works: financial advisors buy a representative fraction of the index stock and rebalance it over time, usually in a taxable brokerage account.
Direct indexing is generally best for large portfolios because owning an entire index can be costly. However, this barrier is shrinking as more brokers offer so-called fractional trading, which allows investors to buy fractional shares.
One of the biggest advantages of direct indexing is the so-called collection of tax losses, allowing investors to offset profits with losses when the stock market falls.
According to Cerulli report.
“Direct indexing offers more opportunities to collect tax losses because there are simply more individual shares,” Grealish said.
Financial experts say that direct indexation could offer a so-called tax alpha, generating higher returns through tax-saving techniques.
Indeed, the strategic collection of tax losses can increase portfolio returns by one percentage point or more, according to research from Vanguardwhich can be significant over time.
Easier portfolio customization
Direct indexing may also appeal to those who are looking for a portfolio customization option, such as value-oriented investors who want to exit certain sectors.
“Everyone’s values are a little different,” Grealish said. “So a foundation is rarely the best way to accurately express your values.”
The setting can also be useful for those who own many shares of the same stock and want to diversify their portfolio.
However, direct indexing can be more costly and complex than buying a passively managed index fund, Sachs said.
Although the concept has been around for decades, it is becoming more accessible as large asset managers enter the market and commissions and account minimums are lowered.
“It’s sort of a democratization,” said Pete Dietrich, head of wealth indexes at Morningstar.
According to Dietrich, while platforms with tax features and a value-based investment setup could cost around 0.35% a year and a half ago, today you can see similar platforms around 0.3%, 0.2% or even lower.
In comparison, the average expense ratio for passively managed funds in 2020 was 0.12%. according to Morningstar.
“I think you’re starting to see the minimum account amount is between $150,000 and $250,000 and it goes down to $75,000 very quickly,” he said, noting that some platforms are even lower depending on the platform’s capabilities.