At its most basic, direct indexing is a way of “unwrapping” an index fund or ETF and allowing the individual investor to replicate the index by owning the underlying stocks. Not too long ago, such a strategy would have been overly time consuming and expensive; however, thanks to technology and negligible trade commissions on stocks at many custodians, the doors of opportunity have opened.
With hundreds of low-cost ETFs so readily available and easy to use, why would someone want or need to do this? In a word: taxes. When you hold individual stocks, you have the ability to loss harvest by lot and use those losses to offset gains in other holdings. And there are many ways to use the technology of direct indexing that extend beyond simply replicating an index like the S&P 500 or other broad-market indices. Essentially anything can be the “index” that you are trying to replicate, and you can specify the buy list from which to choose the holdings.
Let’s say that you have an existing portfolio of stocks, held in a taxable account. Many of the stocks are long-term holdings with high embedded capital gains, and as a result the portfolio is not well-diversified. You want to rebalance the portfolio to a particular model, strategy or index but it would be too disruptive to your financial plan to realize more than a certain amount of capital gain. A direct indexing (or portfolio optimization) approach compares your existing portfolio to the “goal” portfolio, and using a specified buy list from which to choose securities, it would recommend trades that would keep capital gains within your budget while attempting to match the characteristics of the model, strategy or index desired.
Another advantage of portfolio optimization is the ability to customize. Let’s say that you want to mimic a particular index or model, but you want to make sure that certain stocks are not included (because you are a socially responsible investor and want to avoid owning companies that you find distasteful, for example). The software will exclude those stocks from the pool of available securities and will use a combination of approved securities to mimic the index or model’s characteristics.
As much of the benefit of direct indexing can be accrued to tax efficiencies, it is generally not recommended for tax-deferred or tax-exempt portfolios. It is easy to rebalance these types of portfolios to a model, and there is no need to hold the underlying constituents of an ETF in order to optimize tax loss harvesting. In a non-taxable account, you could simply own the ETF itself; there is far less portfolio maintenance on the investor’s part, as the fund company handles the periodic rebalancing of the underlying stocks at a very low cost.
For the right type of portfolio, however, direct indexing/portfolio optimization is a tax-efficient way to rebalance around low-basis holdings or avoid certain securities, industries or sectors while still obtaining exposure to the characteristics of an index or model.