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Direct Indexing Captures The Imagination Of ETF Enthusiasts

Advances in financial technology allow investors to look beyond traditional investments. Exchange-traded funds offer strategies and indices with mass appeal, and investors acquainted with ETFs have started to adopt direct indexing to further diversify their portfolios.

Direct indexing allows flexibility of investor tax management, unparalleled customization and the ability for investors to look beyond traditional investments to build and customize their own index implementations.

What Is Direct Indexing?

Direct indexing is when an investor purchases an array of stocks, kept in a separately managed account (SMA) to gain direct exposure to an index or a blend of indices. This is an alternative to holding onto multiple assets bundled together in a package, known as an ETF.

Although ETFs and direct indexing both offer easier ways to diversify, the major distinction is what the investor owns. In a direct index, the investor owns the underlying shares. In an ETF, the investor owns shares of the fund.

Direct indexing gives an investor exposure to the entire index, inclusive of all benefits that come with an index fund. The actual stocks owned can be customized based on the investor preferences, eliminating companies that do not reflect the investor’s interests.

Advantages Of Direct Index Investing

ETFs give investors exposure to indices in a standardized way and they must follow the index provider’s rules. Direct indexing gives the investor an added level of discretion. ETFs need to add or remove shares due to index changes, in return forcing an investor to accept decisions or sell the entire ETF (and potentially incur taxes).

In the past, a deterrent to direct indexing was the high SMA management fees compared to investing in a low-cost traditional index fund, making it especially unattractive for retail investors.  At larger allocations, SMA fees come down as a result of scale, with the added benefit of significant tax savings.

The flexibility of direct indexing enables investors to take advantage of investor tax-management practices not available in the same extent to ETF investors. These two components are commonly used:

» Tax loss harvesting. Tax loss harvesting enables investors who suffer a loss on a stock to sell and use the loss to offset taxable income on other investments. Direct indexing provides stock level liquidity, and any stock losses can be “harvested” and used to offset other gains. This provides greater tax benefits than if the loss were buried in an indexed mutual fund or an ETF.

» Capital gains tax deferral. In a mutual fund or standard index fund, capital gains are not easy to avoid. Taxes are often inevitable, unless the investment is in a qualified tax-deferred vehicle, such as a 401(k). However, direct indexing allows capital gains to be deferred, so these can accumulate tax-free until the investor takes receipt of the profits. By deferring sales, the investor can postpone or defer taxes. The longer an investor delays realizing gains, the more valuable tax deferrals can be. Essentially, they serve as interest-free loans.

Unparalleled customization is another major advantage of direct indexing. Through it, investors can adapt any index, either to change its risk profile or to align it with specific environmental, social, governance or faith-based preferences.

But customization reaches further than only those indices employed by ETFs. Although the investment marketplace is full of indices, those used by providers are mostly created for their mass retail appeal. Beyond that selection, only a small percentage of indices are available as ETFs. The rise of direct indexing allows investors to track underutilized indices with stocks directly or even create their own indices where no suitable ETF exists.

Direct indexing also offers an appealing solution when an investor is explicitly concerned about tax and liquidity. Low volume ETFs are exposed to termination risk, which may result in unexpected capital gains or trading losses. Such investors should consider direct indexing instead.

“Full replication” of an index is where one holds all the constituents of the index in their exact proportions. This is now cost-efficient for small accounts through direct indexing as a result of technological advances in fractional shares. However, certain investors may instead wish to replicate the index, but also narrow their selection to a smaller number of stocks.

By using modern computer optimization, an index such as the broad S&P 500 can be replicated with tracking errors between 1 percent and 2.5 percent and with between 200 stocks to as few as 50 stocks. We call this process “narrow replication” (instead of “full replication”), and it is another powerful direct indexing solution investors have at their disposal today.

The Future

ETFs revolutionized the market for retail investors seeking pooled investments that were tailored to their interests. Although ETFs offer cost-effective and efficient options, investors acquainted with ETFs have begun to adopt direct indexing to further diversify their portfolio.

Direct indexing gives an investor increased control over stock choices versus an index fund and limits exposure to securities they do not want, while staying close to the market.

Perhaps best of all, direct indexing allows investors, with almost any allocation size (starting at a $100,000 initial investment), to replicate any index at ETF-like fee levels, while realizing the tax advantages offered by owning the individual underlying index securities.

Teun Lucas is head of sales and client relations at Optimal Asset Management, a registered investment advisor specializing in the delivery of institutional-grade investment solutions for all investors. Teun can be contacted at [email protected] [email protected].

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