ETF

Direct indexing: The next chapter for ETFs?

ETFs have come a long way since the launch of State Street S&P 500 Trust ETF (SPY) in 1993. ETF is here to stay and in my opinion, it is just a matter of time before the mutual fund structure becomes completely obsolete. I am not saying that mutual funds will be completely eradicated from the face of Earth, instead what I am saying is that the next generation of investors will be talking about ETFs, not mutual funds.

To me, ETFs represent a more efficient investment vehicle than the legacy structure, i.e. the mutual fund structure.

For more information on the differences between ETFs and mutual funds, see: ETF Vs Mutual Fund: What it means for your investment portfolio?

As much as ETF is going to dominate in the investment communities for the next couple of decades, one can’t help but wonder what is the next financial innovation that will eventually overtake ETF, similar to how the growth in the ETF industry has outpaced that of the mutual fund industry.

What is Direct Indexing (DI)? 

Direct indexing means buying and owning all the securities within an index/benchmark directly. For example, if you are to invest in the S&P 500 Index in the form of direct indexing, it means that you are directly buying the 500 securities in the S&P 500 Index.

So instead of owning the wrapper (ETF or mutual fund) that owns the 500 securities in the S&P 500 Index, direct indexing allows you to own the 500 securities directly.

Direct Indexing

Benefits of DI

Customization

If you are interested to invest in the S&P 500 Index and wants to exclude certain companies within the said index, you are out of luck.

With the exception of buying all the securities in the index and excluding the said certain securities, which is the intent of direct indexing, there is no other way for an investor to achieve such customization.

Direct indexing allows such customization to the investors and more importantly, it allows the investor to achieve a truly personalized investment portfolio. This is appealing to investors who are not looking for a one-size-fits-all portfolio solution.

Risk Management 

The ability to add and/or remove certain securities in the fund allows the fund manager to better manage the fund’s overall risk profile.

Such risk management should theoretically allow the fund manager to achieve a better risk-adjusted return.

Tax-Loss Harvesting

One of the key benefits of direct indexing is tax-loss harvesting.

Tax-loss harvesting is the process of selling securities in your portfolio that have dropped in value to offset the capital gains you have realised from selling securities in your portfolio that have price appreciation. The fund structure of an ETF allows opportunities for tax-loss harvesting only at the fund level and not at the security level.

With direct indexing, fund managers can harvest tax tosses at the individual security level which offer more control over the gains and losses throughout the year. It allows the manager to optimize the tax bill and lower the probability of receiving an unexpected tax bill for capital gains.

Tax-loss harvesting at the fund level is sub-optimal as compared to tax-loss harvesting at the individual security level in the fund which is more precise and optimized.

The process of direct indexing will mean buying up all the securities in the index which implies that the transaction costs of buying all the securities in the index will be high as compared to buying an index fund/ETF.

Investing in an index fund/ETF incurs two costs (non-exhaustive):

  1. Brokerage/commission of buying the index fund/ETF
  2. The total expense ratio of the index fund/ETF

Direct indexing also incurs two costs (non-exhaustive):

  1. Brokerage/commission of buying all the securities in the index
  2. The total expense ratio of the managed direct index portfolio

Even with higher total transaction costs, the financial benefits from tax-loss harvesting in a direct indexing portfolio could potentially more than offset the transaction costs of buying all the securities in an index. 

Trading costs in the US have come down quite dramatically for the past couple of decades. And more recently, a price war has broken out between the major brokerages in the US.

Such development should drive down the transaction costs of direct indexing.

For more information, see: Weekly Highlights 13 Oct: How US brokers survive with 0 commission

Gains Deferral

Suppose you need to liquidate some of your investment holdings for cash. If you are holding ETFs, you will need to sell your whole ETF, i.e. selling your ETF is equivalent to selling all the securities in the ETF pro-rata.

With direct indexing, you can choose which securities in your portfolio to liquidate to optimise your tax bill. For example, you can avoid selling securities that have gain in value the most, to optimise your tax bill.

Active in disguise?

In short, depending on how you leverage direct indexing in your investment portfolio, it can potentially be a form of active portfolio management in disguise.

The ability to add and/or remove certain securities in the index, indirectly implies that you have an active view of the securities that you have added and/or removed.

While such active views may be for reasons outside of financial gains such as taking a stance on ESG, gender equality, diversity and etc, it still equates to taking an active role to construct an investment portfolio. However, if you are using direct indexing to own all the securities in the index for cost-saving, i.e. tax-loss harvesting reason, then obviously, this does not equate to active management.

On the other hand, if your sole purpose of using direct indexing is to leverage the platform’s abilities to customize your investment portfolio by removing and/or adding certain securities in a fund, this will equate to active portfolio management.

For more information on the performance of active investing, see: SPIVA: Doomsday for active fund managers?

High barrier of entry for beginners 

Direct indexing requires a lot of work, such as:

  •  Buying and/or selling of securities in the index
    • The bigger the index, the more laborious the work
  • The process of tax-loss harvesting
    • Selling of securities that have depreciated in value
    • Finding similar securities to replace the securities that have been sold off
  • Keeping track of changes in the composition of the indexes whenever the index issuers add and/or remove securities from the indexes
    • Such changes in indexes’ composition will need to be reflected in your direct indexing investment portfolio
  • and etc

In the US, there are a couple direct indexing platform providers such as Wealthfront. However, there is usually a minimum account size to open/activate a direct indexing investment account and rightfully so.

To unlock the full potential of tax-loss harvesting from direct indexing, it requires a fairly large account size, ideally in the mid-six-figure range. For Wealthfront, the minimum account size for security level tax-loss harvesting is $100K.

For more information on Wealthfront’s security level tax-loss harvesting offering, see: https://support.wealthfront.com/hc/en-us/articles/115002980046

This amount ($100K) is usually out of reach for most retail investors starting out on their investment journey.

However, as you progress through life, your investment account size will typically grow in size, that is where you can start to explore direct indexing as an option for you to optimize your tax bill.

At the end of the day…..

It will still be a couple of years for the technology to catch up before direct indexing becomes mainstream to the retail investors and at the same time, commercially viable to the direct indexing platform providers to cater to the mass markets.

As always, take personal responsibility of your financial well-being and do your own due diligence.

 

 

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Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.

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