Choosing the right tool for the job. It’s a maxim that has withstood the test of time, because it applies to nearly every situation. Whether you’re building a chair, figuring out the best software program, or preparing a meal, understanding your options and picking the best one for your situation can save time, reduce frustration, and improve the overall experience.
It also applies to investing.
There are so many ways to invest in your future, so many ways to reach your financial goals. Many people, however, only invest in the most basic ways, like contributing to a 401(k) or choosing one or more mutual funds or ETFs. There’s nothing wrong with that — in fact, it’s often the best approach. But there are other investment options available that may be more effective for certain people with specific goals.
I am often asked about these extended options. So, to help investors be aware of the many choices available to them, I have started a new series of monthly messages called, “Advanced Investing.” In each message, I’ll break down a type of investing that goes beyond the basics.
We’ll start with:
DIRECT INDEXING
Maybe you’ve heard about it in the news, or from a colleague, or while scrolling on social media. (Or maybe you’ve never heard about it and have no idea what I’m talking about.) Either way, direct indexing is a strategy that has surged in popularity in recent years.
But what is it, exactly? Who is it for? What are the pros and cons?
Let’s start with the word “indexing.” As you probably know, an index tracks the performance of a group of securities, like stocks. The S&P 500 is an example of an index.
Traditionally, index investing means to buy a fund that passively tracks the performance of an index by owning the same shares, in the same proportions. The idea isn’t to outperform the index; it’s simply to match what it does. Index funds are popular because they are generally low cost, and because, while the goal is not to outperform the index, it is designed to track its performance as closely as possible.
Now the “direct” part. With direct indexing, you don’t buy a fund. Instead, you buy each of the individual stocks that make up an index. From there, you can decide to hold some stocks in greater or lesser proportion than others or even skip some stocks entirely if they don’t match your needs for whatever reason.
Because buying so many individual shares can be expensive, this strategy was once limited only to institutions and extremely high net worth investors. Today, thanks to technology (and the ability to own fractions of a share), direct indexing is more widely available. But why do it this way at all? Well, direct indexing can bring several advantages that a passive index fund cannot.
Potential tax advantages. With direct indexing, you have direct ownership of the individual stocks in an index. That means you can buy or sell whenever you choose, enabling you to defer capital gains or sell “losing” stocks to offset them. (This is known as “tax-loss harvesting.”)
More diversification. Many indexes are “weighted” so that certain stocks make up a greater portion of the indices’ total value. (For example, the S&P 500 is a capitalization-weighted index, which means companies with a higher market capitalization make up a larger share of the S&P’s overall value.) That means, when you own an index fund, a greater percentage of your money is being concentrated on a handful of companies. With direct indexing, you can control how much or little of each stock you want to own, helping your portfolio stay more diversified.
More customization. Some investors may want to own more or less of a particular sector than others. This could be for financial reasons or even philosophical ones. Either way, direct indexing allows you greater customization of what you own than an index fund.
Every investment strategy brings potential downsides, and direct indexing is no exception. For example, that same customization brings more risk, because you are now deviating from the index you are trying to track. That gives you more potential to outperform the index...but creates more risk that you will underperform it, too. Direct indexing can also cost more than owning an index fund in the form of additional fees. And while fractional ownership makes direct indexing more accessible, it still usually requires much more to directly own all the securities in an index than to simply buy a low-cost fund.
Finally, the tax benefits of direct indexing may diminish over time if the index consistently appreciates in value, limiting your ability to harvest losses.
For those reasons, investors — particularly those in higher tax brackets — who are looking for ways to optimize their taxes may want to consider direct indexing. Experienced investors who are comfortable with staying close to an index but require more customization, or who want to better align their investments with their values, may also want to consider it. On the other hand, this strategy probably isn’t a good fit for those looking to keep costs down or who are investing primarily through their retirement accounts, as tax-loss harvesting only works in taxable accounts.
Ultimately, direct indexing is not a requirement to reach your financial goals, and it’s definitely not right for everyone. In many cases, simpler is better! But it can be a useful strategy for those who want a more personalized portfolio with potential tax advantages.
As always, let me know if you have any questions. In the meantime, have a great month!
Disclosure: Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss. Indexes cannot be invested in directly, are unmanaged and do not incur management fees, costs and expenses. Past performance is not a guarantee of future results. Tax-loss harvesting does not guarantee a tax benefit. Tax consequences vary depending on individual circumstances. Consult a qualified tax professional regarding your specific situation.