The past 100 years have shown us rapid development in investment strategies and market technologies. We’ve seen new types of stocks and bonds, the introduction of exchange-traded funds (ETFs) and mutual funds, and hedge funds that give investors inside access to private investments. Today, we’re seeing the rise of a new type of investment strategy called direct indexing.

Direct indexing is the practice of owning the shares of an index in the same proportions as the index itself, without paying a third-party manager to select stocks and maintain the allocations. While the concept of direct indexing has been around for years, it has only recently become a viable option for the majority of investors because of the advances in stock-trading technology.

We have identified three primary benefits of direct indexing in its current form:

• Reducing management fees in a portfolio
• Fractional share trading & zero-commission equity trading
• Tax-loss harvesting and tax-loss carryforward

Below, we explain these benefits as they pertain to the investor and recommend an approach investors can take to harness these benefits.

Management fees, or expense ratios, are the costs to the investor associated with owning a fund (an ETF, mutual fund, or other funds). Asset managers are paid these management fees for their work selecting stocks, determining the proper allocation, and maintaining the fund. However, to the investor, these fees introduce a hurdle an investment must overcome in order to become profitable.

A higher management fee is a higher hurdle for the investment. Generally, when an investor selects an investment, they decide that the cost of the management fee is worth the expected return from the performance of the investments inside the fund. Sometimes, the higher management fee is a premium for access to more thoroughly-researched investments or investments that analysts have determined to be poised for outperformance. It is not always the case that the fund outperforms its management fee.

Here, we see an opportunity for direct indexing. By bypassing the third party and owning the investments directly, an investor can closely replicate the fund’s holdings in their own portfolio to the same proportions as the fund. In doing so, the investor effectively removes the management fee from their performance calculation, minimizing the hurdle their investments have to overcome to be profitable.

On the other hand, an investor becomes solely responsible for maintaining the investments to the same proportions as the funds themselves. The choice here represents an opportunity cost between the time it takes to maintain the proportions in investments and the management fees.

A key to the strategy of direct indexing is owning the stocks in the same proportions as the underlying fund.

With the new advancements in trading technology along with the recent elimination of trade commissions at some of the larger custodians, an investor can invest in fractional shares of a company or ETF instead of being limited to purchase whole number shares. For direct indexing, this significantly increases the control an investor has over the dollar amount they can choose to allocate to direct indexing.

In the past, trade commissions would add up to become a significant cost to the investor. Now that trade commissions have been eliminated, investment strategies that once would have cost thousands of dollars to execute now are available to investors at no cost.

Tax-loss harvesting is the practice of selling securities at a loss with the intention of offsetting current or expected capital gains in their portfolio. For example, an investor who realizes $3,000 of gains and $3,000 of losses has a capital gains tax liability of $0. The same investor, without realizing losses, would instead have a capital gains tax liability of $3,000 in short- or long-term capital gains. This holds true for many security investments.

While invested in an ETF, an investor only sees the total return of their investment into the fund, not the performance of the underlying securities. A direct index gives the investor insight into individual securities’ performances. With this information, an investor can see whether a security is at a gain or a loss and decide whether or not to sell the security, realizing a gain or a loss.

An investor who decides to sell securities currently sitting at a loss within their direct index can use those capital losses to offset gains elsewhere in their portfolio. Instead of having to sell the entire fund (which may or may not be at a loss), the investor gains a greater degree of control over the index and can decide which securities to sell and repurchase, and which to keep and hold.

One potential outcome of this strategy is that eventually, there may be no losses to realize within the direct index. If this becomes the case, we recommend talking to your financial advisor for more information on strategies to avoid accruing a significant amount of capital gains taxes.

To recap the concepts we’ve covered so far, successful direct indexing includes:

• Minimizing management fees/expense ratios
• Purchasing fractional shares
• Deciding on an allocation to directly indexing a current fund
• Harvesting losses for tax purposes

While direct indexing can be a powerful addition to an investor’s current portfolio, supplementing a direct index with other investments that complement the direct indexing strategy can create a well-rounded, well-positioned investment portfolio. The direct index is a part of a portfolio, like a fund or stock investment - it is not a silver bullet to replace an entire portfolio.

Many of our clients currently have direct indexes we manage on their behalf. If you or someone you know may be interested in forming a direct indexing strategy, please reach out to us or your current investment advisor to learn more about how you can add direct indexing to your portfolio.

Our approach to Direct Indexing is found in our 4-Quadrant Equity Approach. Below is an example of how we conceptualize Direct Indexing as part of a well-balanced investment portfolio.

If you would like to learn more about Direct Indexing 1.0 or 2.0, or about our custom portfolio process, please reach out to us.