Is direct indexing a better investment strategy than ETFs?

The strategy allows small investors to replicate the performance of an index by directly purchasing individual stocks and adjusting them over time

Direct indexing offers greater freedom and flexibility than ETFs and actively managed mutual funds. Getty

Private investors have grown to love exchange-traded funds (ETFs), which enable them to easily track a host of global markets and maximise their returns by paying impossibly low annual fees.

This has been a welcome revolution, giving power to small investors and saving them from handing over a small fortune in charges to expensive active fund managers.

Yet ETFs do have one big drawback. While they are pretty much guaranteed to match the performance of their chosen index, minus that small fee, they will never actually beat it.

That’s because they are obliged to buy every stock listed on the index, the good, bad and in some cases downright ugly, and passively follow them up or down.

Now, a twist on ETFs offers investors the chance to filter the bad and ugly out of their portfolio, and only buy the good guys.

It is called direct indexing, or sometimes personalised indexing, and helps investors or their advisers build a customised portfolio that offers greater freedom and flexibility than either ETFs or actively managed mutual funds.

The concept has been taking the US market by storm, where it is expected to grow faster than any other investment vehicle over the next four years.

Cerulli Associates expects direct indexing growth to outpace both ETFs and active funds, with average annual growth of 12.3 per cent a year.

Assets invested in direct indexing will almost double to about $825 billion by 2026, up from $462 billion last year, it says in a report sponsored by direct-indexing provider Parametric Portfolio Associates.

Cerulli research director Tom O’Shea reckons direct indexing is ready to deliver “mass customisation” and provide a “silver bullet” for investors, but what does the concept mean in practice?

First, if you have not heard of direct indexing, do not worry. The concept is fairly new and mostly restricted to the US, but then so were ETFs at first, and see how swiftly they have conquered the world.

The key difference with direct indexing is that you are buying the individual stocks on a market rather than all of them, as you do with an ETF or mutual fund.

As well as the cherry-picking benefits, this allows you to replicate the performance of that index by directly purchasing a few of its constituent members and adjusting them over time, says Vijay Valecha, chief investment officer at Century Financial.

Since you own the individual stocks, you can adjust your holdings to fit your specific circumstances.

“Unlike one-size-fits-all ETFs or mutual funds, you can customise your portfolio to, say, include more tech stocks and fewer utility stocks,” he says.

If an investor already has a large stake in an individual company listed on an index they want to track, direct indexing allows them to exclude that company from their portfolio.

For example, somebody who made a large bet on electric carmaker Tesla might be reluctant to double down by buying it in a tech tracker, too.

The same might apply if an investor already owns a heap of shares in their employer and don’t want further exposure when buying the index it is listed on.

Direct indexing also allows investors to exclude a stock or sector on environmental, social and governance (ESG) grounds, say, if they don’t want to buy into a tobacco manufacturer or a fossil fuel exporter.

This seems to offer the best of both worlds, at least in theory. Passive investing, with active engagement.

Mr Valecha says it has a further benefit as it can offer tax advantages that traditional ETFs do not, known as tax-loss harvesting.

“This involves selling individual securities in your portfolio at a loss, even when the index has climbed as a whole,” he adds.

By doing this, you can generate losses to offset against your capital gains from other positions in the same tax year, potentially lowering your overall bill.

“Over time, these incremental tax savings can add up significantly,” he says.

Vanguard Personalised Indexing automatically scans investors’ portfolios each day for tax-loss harvesting and rebalancing opportunities, helping them optimise holding periods and offset capital gains and losses.

This strategy is not an option when investing in standard ETFs because you own only interests in the fund, rather the individual securities, Mr Valecha adds.

One drawback is that it takes time and effort to identify and purchase the securities.

“Some of the stocks may not be easily available for purchase, making it difficult for smaller investors to obtain them at a reasonable price,” Mr Valecha says.

Until recently, only large, institutional clients or high-net-worth investors could tap into direct indexing, but now platforms such as Fidelity, Schwab, BlackRock, Vanguard and Morgan Stanley are opening the concept to a much wider market by offering cheaper, automated services.

How much you need to access the service varies. For example, Fidelity offers it from $5,000 while Schwab's minimum investment is $100,000.

Jason Hollands, managing director of fund platform Bestinvest by Evelyn Partners in the UK, says the supposed tax advantages of direct investing will depend on the country.

“In the UK, for example, investment fund structures are highly tax-efficient as trades within funds do not incur capital gains tax liabilities. You only crystallise a gain when you sell shares in the fund itself, so there is no real benefit here.”

Giles Coghlan, chief market analyst, consulting, for brokerage HYCM, suggests the ability to exclude individual stocks may be overrated.

“Even if one stock drops deeply, if it is part of a larger index like the S&P 500, it isn’t particularly damaging to your portfolio.”

David Morrison, senior market analyst at Trade Nation, says this remains a niche area and for most investors, ETFs remain the simplest and cheapest option.

“Direct indexing demands time and effort, either from you or your financial adviser. That means there will be management fees and commissions, if actively buying and selling individual stocks within the index.”

These may be offset through tax savings, but the process will work best on larger portfolios, which offer economies of scale.

“By contrast, it’s relatively cheap to buy and hold an ETF, although you have no control over what’s in it,” Mr Morrison says.

For most investors, ETFs will be enough. Having more control is great, unless it comes at the cost of even greater complexity.