Direct indexing is being “democratized” as fees and minimum accounts go down

As demand for specialized portfolios grows, a trend known as direct indexing is quickly becoming an option for more investors.

Instead of owning a mutual fund or exchange-traded fund, direct indexing buys the stocks of an index to achieve goals like tax efficiency, diversification, or value investing.

Traditionally used by institutional and high-net-worth investors, direct indexing is expected to grow more than 12% per year, faster than estimates for mutual funds and ETFs, according to 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 space and are looking to broaden their reach.

“It’s telling that these big fund providers are embracing direct indexing,” said Adam Grealish, head of investments at Altruist, an advisory platform with a direct indexing product.

This is how direct indexing works

Charles Sachs, a board-certified financial planner and chief investment officer 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 portion of an index’s stocks and rebalance them over time, usually in a taxable brokerage account.

Direct indexing generally works best for larger portfolios, as owning an entire index can be expensive. However, this barrier is shrinking as more brokers offer what is known as fractional trading, which allows investors to buy fractional shares.

Boost portfolio returns by accumulating tax losses

One of the biggest benefits of direct indexing is what’s known as tax-loss harvesting, which allows investors to offset gains with losses when the stock market falls.

According to a Cerulli report, more than half of actively managed accounts are not treated for tax purposes.

“Direct indexing offers more opportunities to reap tax losses simply because there are more individual stocks,” Grealish said.

Direct indexing offers more opportunities to reap tax losses simply because there are more individual stocks.

Adam Grealish

Head of Investments at Altruist

Financial experts say direct indexing can provide so-called tax alpha, which yields higher returns through tax-saving techniques.

According to Vanguard research, strategic tax loss management can increase portfolio returns by a percentage point or more, which can be significant over time.

Easier to customize your portfolio

Direct indexing may also appeal to those looking for customized portfolio customization, such as B. value-oriented investors who want to divest certain sectors.

“Everyone has slightly different values,” Grealish said. “So a fund is rarely the best way to pinpoint your values.”

The adjustment can also be handy for someone with many holdings of a single stock who wants to diversify their portfolio.

However, direct indexing can incur higher costs and more complexity than buying a passively managed index fund, Sachs said.

Direct indexing is “democratized”

Although the concept has been around for decades, it’s becoming more accessible as large money managers enter the space and fees and account minimums decrease.

“It’s kind of democratized,” said Pete Dietrich, head of wealth indexes at Morningstar.

While platforms with control features and value-based investment adjustment cost about 0.35% a year and a half ago, similar platforms today may cost about 0.3%, 0.2% or even less, Dietrich said.

In comparison, the average expense ratio for passively managed funds was 0.12% in 2020, according to Morningstar.

“I think you’re starting to see an account minimum of around $150,000 to $250,000 that goes down to $75,000 very quickly,” he said, noting that some platforms are even lower depending on platform capability. Direct indexing is being “democratized” as fees and minimum accounts go down

Drew Weisholtz

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