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Build Your Own?

Mike Zaccardi, 12:48 pm ET

THE LATEST BIG NEWS in the money management world: Vanguard Group said it had completed the acquisition of Just Invest, while Franklin Templeton announced it was buying O’Shaughnessy Asset Management. With these purchases, the two firms entered the direct indexing arena in a big way.

Direct indexing—or custom indexing—involves using quantitative tools to tailor a portfolio’s individual stock and bond holdings to each investor’s preferences. Say you don’t want to own tobacco stocks. No problem. The direct indexing system constructs your portfolio to hold all companies except smoking stocks.

Some say direct indexing is just active management in disguise. Those critics assert that investors should be wary of fees that are higher than off-the-shelf index funds. Meanwhile, proponents contend that direct indexing offers a host of benefits, including these three:

1. Automated tax management. Direct indexing can perform tax-loss harvesting, realizing capital losses to offset existing gains and potentially generating an additional $3,000 in losses to offset ordinary income.

2. Behavioral benefits. Think “the Ikea effect.” When people build something themselves, they don’t want to let it go. If you craft a portfolio based on your wants, you might be more likely to stick with it when markets turn sour.

3. Managing concentrated positions. In the past, J.P. Morgan Asset Management has published a chart in its Guide to the Markets showing how investors in certain regions were overweighted in specific sectors, such as energy stocks in the South and technology shares in the West. One reason: Employers compensate workers with company stock. Direct indexing could help mitigate this concentration risk by creating portfolios that avoid additional shares from the same sector.

Direct indexing is getting a lot of buzz in the financial advisory world. But I don’t think investors should rush in. Let others figure out whether the concept has legs. You won’t go far wrong sticking with those off-the-shelf index funds.

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Roboticus Aquarius
Roboticus Aquarius
9 days ago

That seems like sound advice to me. I’m sure people will pay for this ability, but I doubt there is great value in it.

On the other hand, I suspect it will become a very handy tool for ESG investing.

Harold Tynes
Harold Tynes
10 days ago

DFA has announced a direct indexing program.

Randy Dobkin
Randy Dobkin
11 days ago

I wonder how tax loss harvesting is done without going afoul of the wash sale rule and while maintaining exposure to all stocks in the custom index. It’s not like with funds where you can replace harvested funds with similar ones.

Andrew Forsythe
Andrew Forsythe
11 days ago

Mike, thanks for the education as I’d never even heard of it.

Mike Zaccardi
Mike Zaccardi
11 days ago

Thanks, Andrew. A lot is happening, but not quite at the individual investor level yet.

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