Direct Indexing: Pros and Cons of the Latest Investing Strategy to Go Mainstream

Author : Mallika Mitra
Originally Published : Aug 12, 2022
Reposted from :Money

Original article
Everyday investors now enjoy many of the benefits once saved only for professional Wall Street-ers.

They can buy and sell stocks and bonds with just a few clicks of their smartphones. If they want, they can participate in complex, risky moves like options trading. And anyone can have information on the latest investments like cryptocurrency and NFTs at their fingertips.

The latest trend that used to be limited to the pros and the very wealthy? Direct indexing.

You’re probably familiar with index funds, which include mutual funds and exchange-traded funds (ETFs) that allow investors to put money into a specific part of the market. But direct indexing allows for a hands-on approach and customization, whether investors want that to pick up stocks they think will do well or to avoid investments that don’t align with their values. It can also make it easier to take advantage of tax-loss harvesting — a perk that can help investors offset their income and thus lower their tax bill.

Investing giants like Charles Schwab and Fidelity are getting in on the action lately by offering direct indexing to retail investors.
But direct indexing can also be tricky, and there’s the potential for investors to be drawn into speculation and short-term trading, says Daniel Needham, president of Morningstar’s wealth management solutions group.

“Direct indexing is not for everybody,” Needham says. “It’s going to be an appropriate strategy for some individuals and not for others.”

Here’s everything you need to know about direct indexing, its growing popularity and whether it makes sense for you.

What is direct indexing?

You should be familiar with index investing if you have money in indexes like the S&P 500. These funds let you invest in a broad range of stocks, allowing for diversification and lower risk compared to picking individual stocks. But direct indexing is an approach to index investing that’s different from just buying an index mutual fund or ETF.

Direct indexing allows investors to buy the individual stocks in an index directly as opposed to owning a preset group of stocks through a fund. This means investors can customize their holdings as they see fit, but still (ideally) maintain the performance and risk-lowering benefits of the fund.

In theory, you could do direct indexing on your own by selecting the securities to buy from a fund while adjusting those picks as you like — but that’s complicated and not ideal for most everyday investors. If you have a financial advisor, they can also help you with direct indexing.

There are also platforms now offering direct indexing as an option to retail investors. For example, with Fidelity’s Solo FidFolios direct indexing offering, investors can choose among theme-based models built by Fidelity analysts (like clean energy or cloud computing), decide how much to invest (as little as $1 per stock) and then add or remove stocks.

The benefits of direct indexing

If you own an index fund, you don’t have a choice which stocks are included, and you wouldn’t be able to sell individual stocks within the fund; instead, you’re stuck with the whole bunch.

Direct indexing lets investors decide which stocks to own and which ones to skip. From an environmental, social, and governance (ESG) perspective, direct indexing allows investors to avoid stocks that don’t align with their values. For example, if you don’t want to invest in gun stocks, you don’t have to.

Another advantage of direct indexing is the ability for tax-loss harvesting. This is when you sell an asset when its price is lower than the price you paid and use those losses to offset the gains elsewhere, lowering your tax bill. Since you’re dealing with individual stocks when direct indexing — not one basket of stocks as you would with traditional index investing — there’s more opportunity for smart tax-loss harvesting.

Direct indexing is going mainstream

Direct indexing has traditionally been used by wealthy and institutional investors. But that’s changing. In 2021, research and consulting firm Cerulli Associates reported that the investment strategy was primed to grow at an annualized rate of over 12% over the next five years.

Major players in the investing space are jumping on the direct indexing bandwagon. In 2021, Vanguard announced its acquisition of Just Invest, which added direct indexing to the company’s product lineup for advisors, and in March, Charles Schwab launched its new direct indexing offering Schwab Personalized Indexing for advisors and retail investors.

Earlier this year, Fidelity introduced its own direct indexing option for retail investors. The company has seen investors want more customization, especially among those who Josh Krugman, product area leader for brokerage at Fidelity, calls the “Reddit crew.” (Reddit has become a popular social media platform for active traders to share advice, gather to pump up meme stocks like GameStop and AMC, and celebrate their wins and mourn their losses.)

“Customers want investment choices,” Krugman says. “We think this is a way to take a portion of their account and customize it for their investing goals.”

Twenty years ago, it wouldn’t have been possible for everyday investors to participate in direct indexing the way they are today, Needham says.

“Technology has really allowed personalization to be done at scale,” he adds, noting that tools readily available to investors today have the ability to move large amounts of data and do complex calculations relatively quickly.

Plus, trading costs have “effectively dropped to zero,” allowing individuals to trade a large volume of securities for very little money, Needham says.

There’s been another innovation that has helped push direct indexing into the mainstream, he adds: fractional shares. They allow investors to buy a small slice of a share — say, a fraction of a share of Tesla for $1 instead of a whole share, which has cost over $1,000 in the past.

“[Fractional shares] have meant that individuals with relatively small balances can hold diversified portfolios of equities,” Needham says.

Is direct indexing worth it for you?

Like Needham said, direct indexing isn’t for everyone. So who should consider it?

“Generally it’s going to be the high net worth households and those who have taxable assets,” Needham says.

Direct indexing makes the most sense for investors who have a large sum to invest and are in a higher tax bracket, says Kirsten Crane Cadden, certified financial planner and associate advisor at Warren Street Wealth Advisors, based in Tustin, California. Ideally, they have cash to invest rather than an account already fully allocated among index funds, mutual funds and ETFs, she adds.

There’s no hard and fast rule, but Needham sees direct indexing as a tool to consider for investors with at least $150,000 to $250,000 available to invest and additional capital gains that can be offset by losses. Christopher Lyman, certified financial planner at Allied Financial Advisors in Newton, Pennsylvania, says his firm only considers direct indexing for clients who have $250,000 in non-retirement investment accounts and earn a salary above $200,000 if single or around $400,000 in household income if married.

While you can engage in direct indexing on your own, most investors who do it are working with a financial advisor, according to Morningstar.

However, almost any investor can participate in direct investing, and new brokerage offerings are aimed at making it more accessible. With Fidelity Solo FidFolios — Fidelity’s latest direct indexing offering — investors are able to start direct indexing with just $1 per stock plus a flat monthly fee of $4.99, and select up to 50 stocks in each portfolio, according to the company.

In response to the critique that the tax benefits of direct indexing may just be helpful for high net worth individuals, Rich Compson, head of managed accounts at Fidelity told Money via email that 95% of its clients in tax-managed strategies similar to Fidelity Managed FidFolios saw tax savings that fully covered their advisory fees. (Fidelity Managed FidFolios, which was launched before the most recent offering, comes with advanced tax management techniques and has a $5,000 investment minimum.)

Direct indexing: What are the risks?

Investors who take on this investment strategy should understand that they may end up with a long list of holdings and a longer statement, which can prove complicated, says Lisa A.K. Kirchenbauer, a certified financial planner and founder of Omega Wealth Management based in Arlington, Virginia.

In order to justify the leap into direct indexing, you really need to want to hold individual stocks versus ETFs and think you’ll benefit from the tax management possibilities direct indexing offers, she adds. Plus, it should be very important to you to have direct control over what you’re investing in. If you’re more of a passive, set-it-and-forget-it kind of investor, direct indexing probably doesn’t make sense for you.

There’s also the potential downside of an investor being tempted to buy and sell unnecessarily.

“Think about the risk that an individual goes into their portfolio and they see they have 100 securities and 50 of those are down and 50 of those are up and they just react by selling the ones that are down and buying more of the ones that are up,” Needham says. “The potential is that somebody who would benefit from a sensible, long-term savings plan like owning a couple of low-cost ETFs could be drawn into trading and speculating.”

Don’t forget: If you buy and sell often, you’re more likely to find yourself with short-term capital gains, which are taxed at a higher rate than long-term capital gains. Though the cost of direct indexing is dropping, but it still tends to have higher fees than simply buying an index fund, so make sure to do your homework. Look at how much you’ll be paying to participate to evaluate if this method makes sense.

And if it feels too complicated, Needham says, that’s a sign it may not be for you.