What Is Direct Indexing?
Direct indexing has been around for many years but did not get a lot of attention until index funds became popular. Index fund companies such as Vanguard’s Total Stock Market Index Fund (VTSAX) have seen their assets under management (AUM) surge since the financial downturn of 2008.
When these funds became popular, many investors found that index funds made a lot of sense. They could get exposure to most of the stocks in a market index for a very low expense ratio with no transaction costs. Exchange-traded funds (ETFs) also gained in popularity when these index funds made their debut. ETFs track indexes and trade on the exchanges like stocks do.
But what gets overlooked a lot of the time is that index funds are limited in what they can buy. Index funds cannot simply buy anything; the stocks in the index have to be available in the market. Also, the indexes have to be investable.
The index funds were coming to mainstream only because the stock exchanges were making the underlying securities available to investors.
Consequently, investors are in essence limited to index funds that track the indexes published by the exchanges. By comparison, direct indexing allows investors to get exposure to an index that is not available on the exchanges. This can happen from time to time. Also, there are cases where the underlying securities in an index of a particular market do not trade in a market for one reason or another.
Why Direct Indexing Can Beat Index Funds
Even after several years of solid stock market returns, many investors are still wondering whether they should place their money with a financial advisor, buy a mutual fund, or open a self-managed portfolio.
I believe the ideal core of any investment portfolio can be accomplished using a combination of passive index ETFs and a robo-advisor (although I would never suggest this for larger accounts!). This article will show you how direct indexing can beat the results of mutual funds and managed portfolios.
Mutual funds are the popular choice to get exposure to stock and asset markets for retail investors, and they have been around for a long time. State Street Global Advisors (SSgA) has a webpage which talks about the history of mutual funds, and it is a pretty impressive and impressive story. The first mutual fund in the US was opened by Massachusetts Investors Trust in 1924.
The marketing strategy is simple: you give money to a professional (your financial advisor or the myopic manager of a mutual fund) and the professionals will manage your money.
It is a great way for the financial professional to earn money (through fees), and it can be a great way to invest for some, but it is not without its disadvantages or catches.
Is Direct Indexing the Next Evolution of Index Funds?
Everyone can agree that active traders are not the best investment options. But what if we could buy an investment that mimics the performance of an index without any of the costs?
This is where index funds come in. They are simply low-cost investment options that replicate the performance of a specific index.
For example, if we wanted to invest in the S&P 500, we could use a corresponding index fund that tracks the 500 largest companies in the United States.
Downsides of Index Funds
The one issue here is that the returns from index funds are not guaranteed to match the returns of the indexes. Instead, these investment products are only as good as the companies within their respective indexes. When a company within the index either declares bankruptcy or is faced with a significant amount of debt, the value of the index changes.
Having a diversified portfolio is one way to mitigate the risk, but over time, every investment holds a risk of losing value.
Another issue with index funds is that they are not optimized and therefore consume too much of your investment dollars. Mutual funds typically have high turnover periods since they are actively managed and are always shifting their portfolios. This makes them more susceptible to taxes, particularly on capital gains, and this reduces your overall investment return.
How to Get Started With Direct Indexing
Doing direct indexing is a lot easier than you may think. All you have to do is find out what funds are most directly related to your index.
For example, let’s say you want to invest in Large-Cap Indexing. There are two main ways to do that. You can go with a Large-Cap ETF. But we will focus on Large-Cap Index funds.
Now, you can go to a website and look up all the funds out there that are related to Large-Cap Indexing. Chase is a good website to use. They’ll give you the current balance, the annual expense percentage and the annual dividend yield.
From here, all you have to do is pick the best Large-Cap Index fund to invest in. Finding the largest funds will be the best for you. You want to avoid the minimum investment fees or the high expenses.