What is direct indexing?

Karen Wallace, Morningstar's director of investor education, throws light on the subject.
By Morningstar |  31-08-21 | 

Index funds are popular investment choices for good reason--they’re often cheap, diversified, and uncomplicated portfolio building blocks.

When you own shares of an index fund, you own the stocks in the index fund indirectly, in the same proportion as the index. For example: Let’s say you invested $100,000 in an index fund that tracks the S&P 500. Because the S&P 500 is tilted toward the largest companies in the market, you have some pretty sizable stakes in some of these big blue chips--nearly $6,000 in Apple; over $5,000 in Microsoft; $4,000 in Amazon, etc.

What Does it Mean to Own Stocks Indirectly?

Indirect ownership means that even though you are exposed to the companies’ fortunes and failures, you don't have the benefits of direct ownership.

For instance, even though you may have thousands of dollars committed to these companies, an invitation to the shareholders’ meeting will not be forthcoming. Nor do you have a say in board member elections--the portfolio manager that runs the index fund votes in shareholder elections on your behalf.

You also can’t buy and sell the underlying securities, or trim any of the positions in the index fund for any reason. What if you thought Apple was overvalued and wanted to reduce your position? You’re out of luck as an index fundholder. What if Facebook’s data privacy and security issues give you pause, and you want to remove it from your portfolio? As an index fund investor, you are stuck holding the stock as long as it’s in the index.

What Is Direct Indexing?

Direct indexing means you own the stocks in the index directly. It’s a pretty straightforward idea, but most people don’t do it, and those who do are usually working with an adviser. For one thing, some indexes track areas of the market that aren’t as "liquid," meaning the component securities can be thinly traded and priced inefficiently. Funds that track such indexes often use a sampling or optimization method to mimic the performance of an index.

But even the S&P 500, which is a relatively compact index comprising very liquid (easily tradable) stocks, isn’t that easily to replicate. One barrier to doing this, traditionally, is that you can’t buy every stock in the index if you don’t have a lot of money to invest. This is essentially why mutual funds were created--they allow investors to pool their money with other investors, so they could buy hundreds or even thousands of securities and build diversified portfolios.

Two things that have made direct indexing a more viable option for more investors in recent years are the rise of commission-free trading, and fractional share stock investing, which allows investors to purchase fractional shares in a certain dollar amount. It works like this: Amazon.com is currently trading at around $3,300 per share, so if we invest $1,000 we would own 0.3 shares of Amazon. Because stock prices vary so widely, having the ability to invest fractionally makes it much easier to match the index’s proportions.

RobinHood, Schwab, and Fidelity are among the brokerages that offer fractional stock investing on their platforms, and Vanguard will soon be rolling out the capability as well.

What Are the Benefits of Direct Indexing?

When you own the stocks directly, you are ultimately the portfolio manager.

That means you can customize the index if you want to. Are there securities in the index that don’t align with your values, from an environmental/social/governance perspective perhaps? Direct indexing allows you to sell them or avoid them. One thing to be aware of: If your version of the index starts to look a lot different from the “real” index in terms of sector weightings and so on, the performance won’t match up either. This is called tracking error.

"What direct indexing does is it tailors an index to meet an investor’s specific circumstances, and optimizes for things like taxes, or ESG exposure, or factor exposure," says Ben Johnson, director of passive strategies for Morningstar.

"Where that lands an investor is a place that looks very different from starting point, which was a broad-based, market-cap-weighted index. But it’s been cut to fit their preferences, so it’s ultimately going to take the shape of a separately managed account. How they get from that starting point to that tailored portfolio is increasingly some sort of software application that brings to bear all of the data around taxes, tax preferences, and tax lots; ESG criteria; factor exposures; you name it."

What Are the Drawbacks of Direct Indexing?

Direct indexing really only makes sense for people who have a considerable amount to invest and want a level of customization.

The selling strategy itself invites risk; perhaps holding onto the slumping stock would have turned out to be the better move in the long term?

There is the tax aspect. If a fund buys and sells stocks, it does not affect you. You are taxed only when you sell your units. Here it will have a tax impact.

In addition, portfolio customization can get really complicated, really quickly. The idea of being able to customize your portfolio from an ESG or factor exposure perspective may be appealing, but keeping track of all the moving data points on 500 separate securities can be daunting.

You would also have to keep tabs on changes in the index--index rebalances and reconstitutions--to make sure you know which securities are added and removed from the index. Traditional index funds and exchange-traded funds do this for you for a (typically reasonable) annual fee.

And finally --watch out for trading expenses (brokerage). Bear in mind that index-trackers are low-turnover strategies, meaning they don’t buy and sell too many stocks. The more you start trading and customizing positions in a direct indexing portfolio, the more possibilities you have to encounter transaction costs, which will ultimately eat into your return.

Is Direct Indexing Right for You?

Ben Johnson answers:

Direct indexing allows investors and advisers to build a portfolio that is quite different from the broad market or a broad-based index fund. Over time that may result in better risk-adjusted returns, but for many active managers, it results in worse returns.

Direct indexing makes a large number of investors effectively active managers. And what we know about active management, about being different from the market, is that sometimes it's going to look right and feel good, and sometimes it's going to look wrong and feel bad.

There could be circumstances where investors would probably be better served--they would have gotten greater returns with less risk--by simply owning broad-based index mutual funds or discretionary active funds.

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