There is a growing trend known as direct indexing, of buying the stocks in an index, rather than owning a mutual or exchange-traded fund, for purposes such as tax efficiency or profitability. value-based investing.
While direct indexing has traditionally been used by very high net worth investors, companies like Morgan Stanley, BlackRock, JPMorgan Chase, Vanguard, Franklin Templeton and Charles Schwab are banking on broader access.
“I think there will be more competition and commercialization of direct indexing in 2022,” said certified financial planner Rene Bruer, co-CEO of Smith Bruer Advisors in Colorado Springs, Colorado.
And it could reach around $ 1.5 trillion in assets under management by 2025, according to a report by Morgan Stanley and Oliver Wyman, up from $ 350 billion in 2020.
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“People want a little more control over what they invest in,” said Michael Whitman, CFP and managing partner at Millennium Planning in Pittsboro, North Carolina. “And when you buy into a mutual fund or an ETF, you are at the mercy of the manager.”
Here’s how it works: Financial advisers buy a representative share of stocks in an index and rebalance over time, usually in a taxable brokerage account.
Direct indexing generally works best for larger portfolios, as it can be expensive to own a full index. However, this hurdle may shift as more brokers offer so-called split trades, allowing investors to buy partial shares.
For example, an advisor can buy 150 to 200 stocks to track the S&P 500, said Ken Nuttall, CFP and chief investment officer at BlackDiamond Wealth in Wilmington, Delaware.
“The beauty is that not all stocks go up,” he said. As some go down, advisers may sell stocks at a loss to help offset overall portfolio gains, a tactic called tax-loss harvesting. Advisors can rebalance monthly, quarterly, or more often during volatile times.
Nearly half of actively managed accounts do not benefit from any tax treatment, according to a Cerulli report.
However, financial experts claim that direct indexing can offer what’s known as tax alpha, delivering higher returns through tax saving techniques.
Indeed, the strategic harvest of tax losses can increase portfolio returns by around one percentage point, Studies show, which can be important over time.
However, since direct indexing is an active strategy, it is more expensive than owning passively managed assets, such as index funds and ETFs.
While the average fee for passive funds is 0.13%, in 2019, according to The morning star, the cost of direct indexing could be closer to 0.30% to 0.40%, Whitman said.
Direct indexing may also appeal to those looking for portfolio customization, such as value-oriented investors who want to divest from specific industries, said Charles Sachs, CFP and chief investment officer at Kaufman Rossin Wealth in Miami.
“It’s a great way to be able to direct your portfolio towards causes that you believe in,” he said.
The personalization of the portfolio can also be useful for a person who owns many stocks of the same stock.
For example, an Apple or Amazon executive may want to diversify by investing in an index without their company’s holdings. Direct indexing can allow them to select their stocks, he said.
While direct indexing may appeal to those looking for more control, experts say it may be too difficult for independent investors.
“It’s almost impossible to go into a brokerage account and buy 100 to 150 stocks and know what you’re doing,” Whitman said.
And it’s not always wise to modify an index, Bruer added. Those considering the strategy should discuss the pros and cons with a financial advisor.