The insight behind this post is based on the Animal Spirits podcast episode dated November 20, 2020 about direct indexing (Animal Spirits: Direct Indexing — The Irrelevant Investor)
Direct indexing is an investment strategy where an investor seeks to replicate the risk/return profile of an index by buying individual securities rather than an indexed ETF or mutual fund. The value proposition is multifold: primarily, investors can frequently realize capital losses, which they would net against realized capital gains, thereby effectively ‘maximizing’ their cost basis in the securities they own. This concept, known as “tax-alpha,” can purportedly boost after-tax portfolio returns by ~1.5% per year. (source: The Value of Tax Alpha | Parametric Portfolio)
Until recently, direct indexing was not practical. Thanks to fierce competition for assets between discount brokerages (hat tip, Robinhood), trading commissions have declined — to $0 per trade at many institutions. Additionally, a strategy such as direct indexing would likely require automation since daily management of hundreds of securities would be impractical for most retail investors.
The use case of this concept is simple: an investor has assets in a taxable account that they seek to ultimately sell at some point before their death. (That is, if a buy-and-hold investor plans to hold their assets until their death, the cost basis of those assets will “step-up,” negating many of the benefits of direct indexing.) I suspect most investors with taxable investments intend to realize gains on at least some of them in retirement or to finance large purchases such as a home.
The main benefit is, as mentioned above, “tax-alpha.” The mechanics of this are relatively straightforward. Consider an investor that opens a direct indexed portfolio and owns the assets underlying the S&P 500. Take a day where, in aggregate, the “market” gained 1%. Individual securities that had fallen on that day could be sold at a short term capital loss, and subsequently used to offset securities sold at a capital gain. By individually owning the assets underlying an index, an investor has greater flexibility in terms of tax management. Parametric Associates estimates this “tax-alpha” to be worth 0.2% to 3.1% per year, depending on market average returns and volatility.
Another benefit the investor has is flexibility in the securities in which they invest. An eco/socially conscious investor could overlay an ESG “tilt” upon their portfolio, by avoiding stocks that they believe to be managed in a shortsighted way. By owning shares of companies, investors would also have greater control over management via proxy votes, a luxury not afforded to investors who only own companies through ETFs or mutual funds.
Additionally, the investor could diversify away from the sector in which they source their income or have other investments. I.e. a Silicon Valley programmer could underweight their employer in their portfolio, for example.
Ostensibly, fees could be lower in this strategy as well. Even some indexed ETFs charge an expense ratio of 5–10 basis points; with free trades at a brokerage, one’s effective expense could potentially be lower than that offered by a fund sponsor.
An investor could also have greater flexibility in securities lending, whereby they lend stocks to short sellers to collect the “short rebate.”
Wash sales must be avoided, which limits the flexibility of such a strategy. Of course, an investor could replace a holding in ExxonMobil for one in Chevron without waiting thirty days, but those two securities have only similar (but not identical) risk/return profiles.
If an investor were to “miss” owning a stock that gained significantly in a short time, their returns may not mirror the index they sought to mimic as closely as they had hoped.
Direct indexing also could require a large initial investment to be practicable. Not all retail investors may be able to create such a portfolio because they are constrained by portfolio size.
I believe direct indexing will grow in popularity over the next decade, because the benefits to investors far outweigh the consequences. It behooves discount brokerages such as Vanguard, Fidelity, or Schwab to develop tools that allow investors to engage in direct indexing. I expect there to be a ‘first-mover advantage’ in the direct-indexing space as there was for Robinhood in compressing trading commissions.
Disclaimer: this is not investment or tax advice.