Direct Indexing - Part 1

I thought I would revisit a topic I covered a year or so ago. I won’t blame you if you don’t remember it as even I thought I wrote about it earlier this year. The topic is that of Direct Indexing. Exciting stuff, right!

As always, let’s begin with an explanation of what direct indexing is. In its simplest terms, it is an investment approach where you are able to build your own index with individual stocks instead of buying the whole index. That is probably as clear as mud.

Maybe I should go a bit deeper. We have indexes, like the S&P500. This index includes the 500 largest US companies and is probably the most common index in the world of investing, at least that I refer to. A simple way to invest in the S&P500 is through ETFs (Exchange Traded Funds) like SPY (SPDR SP500 ETF). For roughly $400, you can buy one share of SPY and own portions of these 500 largest companies. Not a bad deal. The cost to own these stocks is roughly .1% a year. Again, a relatively bargain price.

There are lots of advantages to ETFs and include tax efficiencies and the convenience of trading them like a stock. Mutual funds trade at the end of the day, but ETFs and stocks trade throughout the day. However, there is a deeper level of investing that provides more advantages than ETFs. And this is Direct Indexing.

Let’s keep things simple. Say you want to create your own index that is similar (highly correlated) to the S&P500, but want the ability to buy and sell individual stocks. Maybe you want to include or exclude certain stocks for personal beliefs too. Like you have no desire to own tobacco stocks. Or, perhaps you want to be even more tax efficient than what you can do with ETFs. Well, that is where Direct Indexing comes into play.

Direct Indexing has been around for decades, however, the entry point to utilize this approach was rather high. Building out a personalized index and trading that index took a lot of time and incurred lots of fees. In that last few decades the cost to execute has come down. It continues to come down as more custodians and investment companies get into the Direct Indexing arena. Heck, I listened to a webinar a few months back where a custodian is creating their own Direct Indexing product with a $2,000 minimum. This is quite a change from when the minimum was 7 figures.

Again, let me get a bit deeper on the increased tax efficiency of Direct Indexing. In 2020, the S&P500 was up just over 16%. Of the 500 holdings, 302 were up. The remaining 40% of holdings were down. Now, if you just held the S&P500 there would be no tax advantage to sell as you would be paying taxes on the 16% of gains the S&P500 enjoyed that year. But, what if you had the ability to go into all of your holdings and sell only those with losses? Well, Direct Indexing allows you to do that. In this case you would be able to do some serious tax loss harvesting with those 200ish positions that were down.

I mentioned earlier the ability to get really focused on what companies you want to own in your index. Again, if you own the S&P500 index you don’t have much of a choice. You may not want to own any oil companies, but there is not a whole lot of ability to carve them out. With Direct Indexing you may have the ability to include and exclude certain holdings through screens. In my Direct Indexes I even have the ability to screen based on religious values, such as following Baptist, Catholic or Sharia screens. Then there are screens for things like adult entertainment companies. This is where people start talking about Socially Responsible Investing, which is a broad term and a whole other topic.

There is one last thing I want to cover today with Direct Indexing. It is related to the costs of executing these strategies. Surprisingly, they can be cheaper than owning certain ETFs and most mutual funds. Yes, you read that right. There are a few reasons.

First, technology has come far enough to bring down the cost of effectively creating and executing Direct Indexing. There are still people involved in running these indexes, however, the bulk of the work is done by computers. And of course there are costs to run the programs, pay for the smaller staff, and also the cost to create the programs in the first place. However, it sure is a lot cheaper than paying 1% a year to your advisor for him to trade.

The other part where costs have come down is related to trading costs. Specifically, lack of commissions. You know, the charges old school brokers used to pass along. Think of these broker days for a moment and imagine you were paying $20 for every trade. Well, if your advisor wanted to create an index of the S&P500 for you it would cost $10,000 just to buy all the positions (500 companies times $20 a trade). And this does not even include if you have to sell or buy down the road. You know, trade. Again, this is why Direct Indexing was a 7-figure entry point years ago. We now have so many $0 commission platforms there are no longer the $10,000 costs to just buy the index positions.

I am going to repeat myself with the costs of Direct Indexing. I can build out Direct Indexes at often times the same or lower costs than running ETF-based portfolios. Again, you read that right. Direct Indexing can be cheaper than ETFs and with more advantages.

However, Direct Indexing is NOT for everyone. In next week’s article I will share some pros and cons with Direct Indexing and where I think it makes sense for clients. I know you are as excited as I am😉

I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.