HEARD OF DIRECT indexing? It’s supposed to be the next big thing in investing. Let me tell you why that isn’t likely.
Direct indexing arose from a shortcoming in the way exchange-traded funds (ETFs) work. Most ETFs mimic a market benchmark such as the S&P 500 or the Russell 2000, and are bought and sold on an exchange like stocks. Their main selling point is that there are no active portfolio managers selecting the securities, and that results in reduced fees. Despite their usefulness and broad acceptance, ETFs have at least one flaw: Investors can’t get the tax benefit from portfolio losses unless they sell the entire ETF.
Direct indexing is essentially a separately managed account that replicates a market benchmark. Instead of buying shares in an ETF that holds the entire index, investors buy the individual stocks in the index. Direct indexing proponents highlight two benefits. First is the ability to harvest individual stock losses to offset taxable gains, which supporters estimate could add 1% to annual returns. The second benefit takes direct indexing one step further. It allows investors to tweak the index to build a tailored portfolio suited to their values, interests or outlook.
But there are downsides. Here are four of them:
1. Limited loss-harvesting candidates. Tax management has been an attribute of separately managed accounts since their inception. Investors can realize losses on individual stocks to offset realized capital gains elsewhere, thereby reducing their current tax bill. Investors can also gift the lowest cost basis stocks—and hence the ones that would trigger the biggest tax bills—to a charitable organization and claim a tax deduction.
How does direct indexing differ? It doesn’t—except the portfolio reflects a market index rather than the stock choices of a money manager. The problem with tax-loss harvesting: Investors eventually run out of tax losses to realize, limiting the additional return from tax management.
2. Blurring the lines with active investing. Custom indexing, as described above, is active management by a new name. Do you want to eliminate companies that burn coal? Do you want to eliminate companies that rank poorly on environmental, social or governance criteria? Do you want to add growing companies that are not yet part of the index? If you make those changes, your “index” is no longer an index. You have become an active investor, the very thing investing in an index was seeking to avoid.
3. Expenses. The fees on direct indexing products are 0.15% to 0.35% of assets each year, less than many actively managed mutual funds, but potentially more than triple the price of the most popular ETFs. Direct indexing has been made far more cost-efficient thanks to technology and zero-dollar brokerage commissions. Yet each bit of customization adds complexity to the management of your portfolio and increases costs. What if the product is offered free? The manager is making money somewhere else.
4. Complexity. If you direct index the S&P 500, imagine your statement showing 500 line items and the associated trading activity. And portfolios typically don’t stop at one ETF. Many will hold five to 10 ETFs. What will your statement look like with thousands of line items? How lengthy will the year-end tax statements be?
Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. Check out his earlier articles.