Exchange-traded funds are increasingly popular in asset allocation strategies, as they allow broad diversification. Indexed ETFs are tax-efficient and provide an easy way for retirement savers to include a range of investments in their portfolios.
Another approach is gaining ground, though.
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Direct indexing is an investment strategy in which an investor buys individual stocks to replicate the performance of an index, rather than purchasing an ETF. This approach allows for greater customization.
For example, investors can exclude companies, industries or sectors based on personal preferences, tax strategies or ethical concerns.
A chief advantage of direct indexing is the ability to sell underperforming stocks to offset gains elsewhere. That can reduce the investor’s tax bill.
That process is easier with direct indexing than ETFs, as direct indexing allows you to target individual stocks trading at a loss. With an ETF, you can only sell shares of the entire fund. That limits the ability to benefit from the sale of specific stocks that have losses, to offset gains elsewhere.
While it offers flexibility, direct indexing can be more complex. Here’s how direct indexing might work in any individual investor’s situation:
— Portfolio fine-tuning.
— Potential tax advantages.
— Cost comparison.
— Combining ETFs and direct indexing.
Portfolio Fine-Tuning
With an ETF, you take what you get. For example, an investor holding a substantial position in Microsoft Corp. (ticker: MSFT) stock only adds to that position by purchasing an ETF such as the Invesco QQQ Trust (QQQ).
The key difference between direct indexing and ETFs is the ability to customize portfolio preferences with the former, says Misty Garza, a certified financial planner who is vice president at Bogart Wealth in The Woodlands, Texas.
“If someone has a concentrated position in a particular stock or sector and does not want to add any more exposure, then they can use direct indexing by setting up preferences to avoid that exposure,” Garza says.
Direct indexing also allows for investors to invest in a way that aligns with their religious or personal beliefs by excluding certain sectors or companies in their investment strategy, Garza adds.
“When investors choose ETFs, they do not get to put restraints or guardrails on what the investment firm can hold,” she says.
Potential Tax Advantages
By selling a losing investment to offset capital gains taxes incurred by selling another position, investors can reduce their total tax liability.
That strategy is called tax-loss harvesting, and it’s a significant benefit of the direct indexing approach, as it allows investors to target individual stocks trading at a loss.
“The biggest advantage of a direct indexing approach is the opportunity to regularly harvest losses,” says Matthew Garrott, director of investment research at Fairway Wealth Management in Independence, Ohio.
Garrott points out that despite the S&P 500 being up more than 20% so far in 2024, more than 100 stocks in the index have posted negative returns year to date.
“The direct indexing investor participates in the upside of the index, but also has the opportunity to capture losses on those stocks that have decreased in value since they were purchased, leading to improved after-tax returns,” Garrott says.
Cost Comparison
ETFs have built-in management fees, although those that track an index usually have lower expense ratios than actively managed funds. A managed direct indexing account also has fees, although they are often lower today than in the past.
“Direct indexing used to be more expensive when it was newly introduced or required relatively higher account minimums, but since the process has become much more simplified, doors have been opened to more investors through more affordable costs and lower account minimums,” says John Jones, an investment advisor representative at Heritage Financial in Newberry, Florida.
As the investment industry has moved away from commissions on trades and toward fee-based accounts, investors are often not charged per trade, as was the case in the past.
That’s made the costs of direct indexing more competitive with low-expense-ratio ETFs, Jones notes. He adds that custodial and advisory fees for ETFs and direct indexing are generally comparable.
Combining ETFs and Direct Indexing
Some investors combine the two approaches. How that is done may depend on whether the investor is using a taxable brokerage account or a qualified tax-advantaged account, such as an individual retirement account.
“Direct indexing is going to be most advantageous in a non-qualified account as a tax management strategy, or in a qualified or non-qualified account to avoid a concentrated position,” Garza says.
She adds that ETFs are tax-efficient in that there is very low turnover, so they work well with a direct indexing strategy. That’s because ETFs, by virtue of their structure, generally don’t create a significant tax burden for an investor.
“Because of the personalization of direct indexing, you can use it along with ETFs to create an investment strategy in qualified and non-qualified accounts that matches your goals and objectives,” Garza says.
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Direct Indexing vs. ETFs in an Investment Portfolio originally appeared on usnews.com
