A new kind of index investing is “direct indexing” — a customized basket of stocks that tracks the benchmark of the investor’s choosing. This bespoke approach offers many benefits, including tax-loss harvesting and the ability to tailor a portfolio to one’s preferred style factors or priority issues, such as environmental, social and governance (ESG).
Direct indexing primarily is used by high-net-worth (HNW) investors seeking to optimize after-tax returns, an especially compelling proposition during periods of market volatility. But now, the widespread elimination of brokerage trading fees and growing availability of fractional share trading have driven greater adoption of direct indexing. Financial services consulting and research firm Cerulli Associates predicts that direct indexing’s growth will outpace that of index funds, mutual funds and ETFs through 2026. through 2026.
As consumers demand personalized offerings, the case for direct indexing becomes ever clearer. Here are some advantages that direct indexing can bring to your investment portfolio:
1. ‘Dirty money’: Increasingly, investors in all age groups express concern about how the companies they invest in make money. Direct indexing offers financial advisers the ability to help clients craft portfolios that exclude what they believe to be “dirty money.”
For example, Big Tobacco is anathema for some investors; in fact, some might even view companies with any exposure to tobacco production or sales as unacceptable. In such instances, direct indexing caters to an investor’s intention to build a tobacco-free portfolio. While this level of screening may introduce deviation from an underlying benchmark, investors who are highly motivated by ethics are often willing to accept this increased index-tracking error.
2. Outmoded mutual funds: Once game-changing and revolutionary, Model T automobiles were replaced by more modern vehicles, and traditional mutual funds are soon likely to experience that same fate.
Investors who use mutual funds in taxable accounts, for example, don’t have the benefit of starting with their own individualized cost basis. Instead, they inherit, pro rata, the historical cost basis of the product. Often this creates distributable annual taxable gains, even if they haven’t made a sale, or even worse, are underwater on their investment.
For taxpaying clients, it can be hugely valuable to create a bespoke indexed asset that matches the benchmark’s performance and exposures while engaging in tax-loss harvesting along the way. This capability is now “table stakes” when using direct indexing.
3. The age of personalization: Whether it be values, impact, taxes or ethics, HNW investors increasingly expect their wealth manager to offer customized solutions. Traditional index funds/ETFs have a place in portfolios, but offer shareholders zero say regarding the securities embedded in the investment’s portfolio.
Certain wealthy families, including those with secure multi-generational wealth, may care more about how they earn money than how much money they make. Families in this enviable position have the luxury to build values-based portfolios, so buying an index without values-aware customization makes no sense. Consider working with a financial adviser with the proper tools, who can customize a portfolio to align with your family’s values.
Jonathan Foster is president and CEO of Angeles Wealth Management.
