A Direct Indexing Approach to Investing

If you read financial information on social media or subscribe to publications, you very likely have seen references to direct indexing. What is it and is it something you might consider? First, a quick review of indexing as the term is used in investing.

What Is Indexing?

According to Investopedia, “An index is a method to track the performance of a group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market.”

Common examples of indexes are the broad-based Standard and Poor’s 500 Index or the Dow Jones Industrial Average. The Dow Jones Industrial Average is a price-weighted index, which means it gives greater weight to stocks in the index with a higher price.

The S&P 500 Index is a market capitalization-weighted index, which means it gives greater weight to stocks in the S&P 500 Index with a higher market capitalization. (Market Capitalization is the total number of publicly traded shares times the market price per share.) Indexes can also be more specialized, however, such as indexes that track a particular industry or segment.

Indexing is referred to as a passive investment strategy. A passive strategy copies the weight of a pre-determined group of securities in contrast to an active strategy which selects securities based on analysis of past and prospective performance. Active investors anticipate market outperformance where passive investors track the market.

The premise behind index investing is that markets, in general and over long periods of time, are largely efficient, so there is no systematic way to “beat the market” and earn excess returns on a regular basis. Therefore, owning an index provides a representative and well-diversified portfolio. Some studies have shown that most actively managed investment strategies fail to consistently beat their benchmark, especially after taking into account fees and taxes.

How Is Direct Indexing Different?

“Direct indexing is an approach to index investing that involves buying the individual stocks that make up an index, in the same weights as the index. This contrasts with buying an index mutual fund or index exchange-traded fund (ETF) that tracks the index.”

If you wanted to direct index the Standard and Poor’s 500 Index, for example, you would purchase each of the 500 individual stocks in the index in the exact weight as the index. How is that possible? Until recently, direct indexing made sense only for large investors and typically would be more costly to implement and maintain than owning an index fund.

As stock trading fees have dropped, some to zero, it has become more practical to mirror indexes that were previously only cost-effective via index mutual funds or index ETFs. Also, with the increasing availability of fractional shares, it is easier to replicate even a large index with modest sums of investible dollars.

What Are Some of the Pros and Cons to Direct Indexing?

Some investors find that direct indexing provides greater autonomy, control, and tax advantages over owning an index mutual fund or an index exchange-traded fund. Although the goal is to track an index, a direct indexer can control the timing of purchases and sales. An index ETF or index mutual fund manager attempts to track the index but sometimes there is a lag which can cause tracking error. There are also management fees, taxes, and rebalancing costs associated with index ETFs and index mutual funds.

On the other hand, direct indexing can be time-consuming. You must identify all the stocks in an index and compute how many shares you must own given the amount of money that you will be investing. Even if this comes at almost no cost in commissions, it takes time to place orders. That means some index components will rise or fall as the index is being constructed which will change the weights. It is also possible that some of the stocks in the index are illiquid which means that a small investor may not be able to buy them at favorable price.

The professionals are taking notice of the popularity of direct indexing. Because it can be time-consuming to build an index one stock at a time, many brokers have begun offering direct indexing services to their customers. If this strategy appeals to you, there are many resources online to learn more and you may want to check with your investment advisor or brokerage house. Keep in mind that a professional may charge a fee for their assistance.

Let’s Have a Conversation:

Have you heard of direct indexing? Have you used this strategy? If so, what is your experience?