Is Direct Indexing A Better Investment Strategy?



What if instead of buying mutual funds & exchange-traded funds (ETFs) to construct a portfolio, you owned all the underlying stocks and bonds themselves?


Imagine the customization potential. For example, instead of accepting all the stocks comprising the S&P 500 index, you were able to reconfigure its holdings to reflect only the index constituents you wanted to invest in. Pretty cool, right?


You could focus on dividend-paying stocks if portfolio income was your primary goal. You could avoid stocks nestled in the energy or utility sectors if those aren't your cup of tea. You might tilt all of your holdings towards value or momentum stocks to capture higher expected returns.


Consider the vast array of possibilities with direct indexing.


direct indexing
Source: MSCI



WIDELY ACCESSIBLE


When I started my career over a decade ago, only investors with several million dollars had access to this level of sophistication. Buying individual stocks and bonds involved massive amounts of research, and the implementation for asset managers was cumbersome and time-consuming.


Times have changed. Direct indexing has gained popularity as progressive investors don't always feel good about "off the shelf" products like mutual funds and ETFs. The movement towards ESG-screened investments has been a catalyst for direct indexing.


In addition, the technology of dissecting an entire universe of investable stocks and optimizing a portfolio based on investor goals has evolved.


Today, direct indexing minimums on various brokerage platforms are within reach of investors with a few hundred thousand of assets.




BENEFITS


First and foremost, investors feel more connected to their investments.


Think of that friend of yours that bought land, then worked with a builder to construct their dream house. That person likely feels more pride of ownership than the rest of us that bought existing homes.


The other potential benefit of direct indexing is tax reduction. Investors utilizing direct indexing can typically capture investment losses to a greater degree than investors holding mutual funds & ETFs.


The way this works is when an investor sells an investment at a loss, they're eligible to net that loss against capital gains or even against other forms of income on the tax return.


This concept is referred to as tax-loss harvesting.


When a portfolio holds a few hundred individual stocks (or bonds), the opportunity to harvest losses can be 20x to 30x greater than a portfolio holding 10-15 funds.


In my experience, this can come in handy for investors that 1. hold highly appreciated stocks they want to divest from, and 2. have sold real estate or businesses subject to capital gains.


However, my experience has also shown me that the benefits of tax-loss harvesting are overblown by asset managers. I dedicated a whole post about it HERE.


The other tax benefit of direct indexing is you avoid the year-end capital gains distributions of mutual funds and ETFs.


Mutual funds and ETFs buy and sell underlying stocks and bonds throughout the year. Gains associated with selling stocks are passed onto shareholders each December in the form of a dividend.


When you own mutual funds and ETFs in a taxable brokerage account, those year-end dividend distributions count as income and are therefore taxable.


Owning individual stocks and bonds doesn't subject a taxpayer to this additional income. With a direct indexing approach, you get to choose when you sell holdings. This control is advantageous for investors during years when they want to minimize income such as years when they sell investment property, earn large bonuses at work, or execute Roth Conversions.


Last, direct indexing helps address the risk of a concentrated portfolio.


For example, let's say you own a significant amount of your company's stock options or you inherited a few stocks from your deceased parent.


In these scenarios, tailoring a portfolio via direct indexing allows you to omit purchasing more of your concentrated holdings compared to a portfolio of funds where you're likely doubling up on stocks you already own.


This strategy helps mitigates the risk of overexposure to a single stock; a valid goal for any diversified portfolio.




PITFALLS


Direct indexing is far from perfect. It's messy.


Imagine opening your brokerage statement and seeing 10+ pages of holdings consisting mostly of stocks you've never heard of. This makes it difficult to keep focused on your big-picture portfolio strategy.


Further complicating the portfolio is the tax reporting. Without robust software or a perfect digital feed between your brokerage platform and TurboTax, tracking cost basis, capital gains, and dividend income on hundreds of stocks becomes a nightmare.


Direct indexing can be more expensive. I'm not talking about the advisory fee you pay to a "subaccount" asset manager for implementation. These fees are similar to the expense ratio you pay when you buy a mutual fund or ETF so this type of fee is a wash.


It's trading fees that can add up. At Aspen Leaf Wealth Management's custodian, TD Ameritrade Institutional, non-U.S., foreign domiciled stock trades as well as small "over the counter" U.S. stocks incur a $6.95 trading commission.


Let's say you purchase 250 stocks, 40% of which are foreign and subject to TD's $6.95 trading commission. That's $695 of upfront cost sucked out of your account to buy into a direct index portfolio.


Since the portfolio will need to be rebalanced periodically, every time a stock subject to a trading commission is sold and replaced with a "buy" of something else, that's $6.95 2x.


Direct indexing strategies typically hold a few hundred stocks & bonds. That's not actually that much. The two main reasons for the relatively low numbers of holdings are trading costs and the weeding-out effect of customization.


I'd be remiss if I didn't point out the obvious lack of diversification of a direct indexing strategy compared to owning a robust, globally diversified portfolio built with mutual funds and ETFs.


To put this into perspective, our "Core ESG" portfolio model holds 1,784 underlying stocks and 4,777 underlying bonds as of July 2021. The model utilizes 12 different mutual funds and ETFs from 6 different product providers. That's a lot of portfolio "stuff".


Is all this stuff necessary? No, but historically the more of the market an investor owns, the less risk that investor takes relative to the long-term reward they reap.


Every major asset class and subsector of the economy is represented by hundreds of underlying stocks or bonds. Compare this to asset class representation when direct indexing, where you'll typically find only a handful of stocks representing the major sectors.


The first graph below gives us a picture of what sectors make up the U.S. economy.


direct indexing
Source: S&P 500 Factsheet, S&P Dow Jones Global Indices

Direct indexing can fall short of portfolio diversification goals when we consider all of the subindustries in each sector.


Source: Visual Capital (click to enlarge)

The sectors and subindustries above cover mostly U.S. large caps. But what about U.S. small caps, developed international stocks, and emerging markets?


What if you own 5 U.S. financial stocks and this sector gets walloped like it did in 2008? The diversification enthusiast in me would rather own 50+ financial stocks spread around the globe to mitigate risk.


Last, financial advisors implementing direct indexing strategies for clients must outsource to a specialized asset manager either within their employing firm or outside their firm.


To ensure operations run smoothly, the financial advisor and the asset manager have to be on the same page.


The number of portfolio constituents, which accounts should be included in the direct indexing strategy, ESG screening, factor tilting (small caps, value, momentum, etc), contributions, distributions including Required Minimum Distributions & charitable donations, tax sensitivity, advisory fees, and asset allocation adjustments must all be initially ironed out and monitored on a regular basis.


With all these complexities, it's easy to see how the ball can be dropped when there are two unrelated parties attempting to work together towards the common benefit for the client.




PERFORMANCE


I know everyone wants to know if direct indexing leads to higher returns. Unfortunately, it's not a simple question.


The whole point of direct indexing is customization. Customization means you're deviating from a benchmark. The degree to which you deviate plays a big factor in how much better, or worse, your returns will be compared to the market.


For this reason, you won't find a direct index provider who readily shares historical performance data. This makes sense though.


If everyone is building their own custom portfolios, how can any one of those existing portfolio's returns represent an appropriate benchmark to measure against your own portfolio goals?


It's like comparing apples against oranges.


Despite the challenges in meaningful performance benchmarking, I'll take my best shot at it.


To do so, I measured the average 1-year trailing return of all client accounts at Aspen Leaf Wealth Management that are using a direct index approach. I stripped out our advisory fee and compared the results to our Core ESG model portfolio using a 60% stock / 40% bond allocation as this was the closest strategy match to our clients who've been direct indexing for at least a year.


I also applied a monthly rebalancing setting in my Morningstar software to best simulate the real-world trading that naturally occurs in client accounts.


Here are the performance results (7/1/2020 - 6/30/2021).


Direct Indexing Return: 17.09%

Core ESG Portfolio Model Return: 22.55%


I know what you're thinking.


This is the part of the blog post when I remind readers that one year of returns is pretty much meaningless. I wish I had a longer time period to measure performance data. I'll have a 3-year trailing return number for comparison by the end of 2021, But for now, we'll have to conduct the assessment with limited data.


Before we form any final performance opinions, I need to say that returns could have just as easily gone the other way.


The performance metrics above do not mean that direct indexing is bunk or that I'm some sort of genius mutual fund picker. All it means is that the farther you deviate from a benchmark, the more your returns will vary.


That result could work for or against you depending on how you customize your portfolio as well as the time period you choose to measure your results.





WHAT YOU SHOULD DO


I can't answer that in a generic blog post. What I can tell you is that despite the clickbait title of this post, no financial planner should claim direct indexing is better or worse than owning mutual funds & ETFs without a thorough examination of the unique facts and circumstances of each individual client.


On the surface, neither is better and neither is worse. They're simply different.


The point of this post is to inform readers what direct indexing is as well as point out its adoption consideration factors.


Aspen Leaf Wealth Management was one of the first Registered Investment Advisors (RIAs) to offer a direct indexing approach combining ESG screening with the historically higher expected returns of Factor Investing.


If anything in this post interests you and you meet our $500,000 recommended portfolio minimum for direct indexing, please click the Contact link in the upper right of your screen to initiate a conversation.


We're happy to walk you through a decision-making process to determine if you're a good candidate or not.