What is Direct Indexing?
Direct indexing is an approach to index investing that involves buying the individual stocks that make up the index in the same weight as the index. This is in contrast to buying an index mutual fund or exchange-traded fund (ETF) that tracks the index.
In the past, buying all the stocks needed to replicate an index, especially for a large index like the S&P 500, would have required dozens to hundreds of transactions, which could be very costly in terms of commissions and fees. However, with the advent of zero-commission stock trading on many online brokerage platforms, this concern has largely gone away.
Nevertheless, because direct indexing requires an investor to know how many shares of each index component to purchase, and to rebalance accordingly from time to time (especially when the make-up of an index changes), Many financial companies now offer automated direct indexing services for individual investors.
- Direct indexing is an index investment strategy that involves buying directly the components of the index at an appropriate weight.
- Direct indexing can provide some investors with greater autonomy, control, and tax advantages over owning an index mutual fund or ETF.
- Once reserved for wealthy investors, zero-commission trading and the rise of fractional stocks have made direct investing available to many small investors,
- Since it can still take time to build a stock index at a time, many brokers have started offering indexing services directly to their clients.
Understanding Direct Sequencing
Until recently, direct indexing only made sense to large investors and is usually more expensive to implement and maintain than owning an index fund. As stock trading fees are effectively reduced to zero, index investors are increasingly interested in taking some control and autonomy over their portfolios, self-replicating indexes that were previously only practical and cost-effective through index mutual funds or index ETFs. Additionally, with the increasing ubiquity of fractional stocks, it is easier than ever to replicate a large index with a modest amount of investable funds.
In addition to greater autonomy, direct indexing minimizes tracking error, or the difference in returns experienced by an index fund compared to its benchmark index. Tracking error can reduce net returns, and it stems from the fact that many index funds and ETFs do not own the exact index, but rather approximate it to reduce their costs. Even if a fund completely mimics an index, management fees, taxes, and rebalancing timing, among other factors, can cause a mismatch. With direct indexing, each stock is placed at the appropriate weighting.
That said, direct indexing also allows investors to modify their portfolios to overweight or underweight certain holdings or sectors relative to the index weighting, a process known as “tilt.” For example, an investor can straddle their portfolio by holding 2% more tech stocks and 2% less utility stocks than the index. This concept is the idea behind the so-called smart beta investing. Direct indexing allows investors to be more nimble and have control over such a strategy.
passive index investing
Since Vanguard introduced the first mutual fund in early 1976, index investments, in total, have grown to accumulate more than $4.3 trillion in assets by 2021, And it is often declared as the best or optimal investment strategy for most long term investors. The idea behind index investing is that markets, in general and over long time horizons, are largely efficient, and therefore there is no systematic way to “beat the market” and earn additional returns on a regular basis. Thus, owning an index provides a representative and well-diversified portfolio. Indeed, many studies show that most actively managed investment strategies fail to consistently outperform their benchmarks, especially when fees and taxes are taken into account.
The easiest and most cost-effective way for investors to engage in a passive indexing strategy has traditionally been to buy shares of a broad-based index mutual fund or index ETF. The managers of these funds try to replicate the benchmark index that the fund tracks (such as the S&P 500 index) by placing the index’s component stocks in the same weight as the index. Since the composition of an index does not change frequently, these funds are able to charge significantly lower management fees, which have been steadily decreasing over the years. For example, as of 2021, the Schwab US Broad Market ETF (SCHB), the iShares Core S&P 500 ETF (IVV), and the Vanguard S&P 500 ETF (VOO) all have annual expense ratios of just 0.03%.
Practical considerations for direct sequencing
While direct indexing may sound appealing, given the autonomy and tracking error benefits it can hold on index funds, there are some drawbacks to direct indexing. First, it can take a long time to identify all the stocks in an index and calculate how many shares you should own, given the amount you invest. For the S&P 500, you would have to buy 500 different stocks by placing 500 separate orders to completely replicate the index. Even if it comes at practically zero cost in commissions, it can take a long time to place those orders sequentially, meaning that some index components will rise or fall in the interim as the index’s value is determined. The construction is being done in pieces. Some stocks can also be quite liquid, which means that a small investor may not be able to buy them at favorable prices all the time.
When it comes time to sell an index portfolio, the same concerns that crop up when buying an index come up again.
As a result, many financial firms have begun to provide direct indexing services to their clients, effectively automating the process and reducing those concerns. Indeed, Vanguard, BlackRock, Inc. (BLK) and Morgan Stanley (MS) all now offer direct indexing for their clients for a nominal fee (which can be larger than owning an index fund). Investors who want autonomy and control over their index portfolio, or who can gain tax benefits from direct indexing, may prefer this route.