You may have read about it in the financial press. Your clients may be asking about it. Here’s a short primer to help you understand it.
If you’re not sure what direct indexing means, you’re not alone. As a term of art, it’s still fairly new. It’s also ambiguous. As our compliance team never fails to remind us, you can’t invest directly in an index. So what exactly is direct indexing?
The first thing to note is that while the name may be new, the strategy isn’t. In fact, it describes what Parametric has been doing for about 30 years: providing an alternative to index mutual funds and other vehicles for investors who want more choice, greater flexibility, and the potential tax advantages that commingled investments simply can’t offer.
Direct indexing has also been making the news lately. A number of providers (Parametric included) have been strategically acquired by larger industry players, pundits have been talking about whether direct indexing will disrupt the industry, and this past August, Cerulli Associates published an extensive research study on direct indexing. (Full disclosure: Parametric sponsored the study.)
I’ve written extensively about direct indexing on our blog and spoken about it at a number of industry events over the past few years, but I want to use this opportunity to take a step back and define direct indexing, answer some common questions about it, and help advisors and their clients understand who may stand to benefit the most from it.
What is direct indexing?
Most of us are familiar with mutual funds and exchange-traded funds (ETFs), which package underlying securities into a single vehicle accessible to investors. Investors purchase shares in an index-tracking ETF, for example, to gain broad market exposure to the benchmark of their choice—the S&P 500®, the Russell 3000®, and so on.
Direct indexing takes this idea in a different direction. Instead of owning shares in a commingled fund, the investor owns the individual securities in the portfolio directly, in a separately managed account (SMA). The investor gets the same kind of broad market exposure but with compelling advantages, including when it comes to improving after-tax outcomes. For example, unlike an ETF, direct indexing allows investors to customize their portfolios to actively harvest capital losses from individual securities. (More on this below.)
Direct indexing, done right, also unlocks other powerful customizations that allow investors who want broad market exposure to step outside what an index provider decides should be in their portfolio. For instance:
- If the investor has ESG principles they’d like to express, they can adjust their holdings to screen out certain industries or particular companies whose business practices they object to.
- If they have a concentrated position in a particular company’s stock, they can avoid redundant or risk-concentrating holdings in their portfolio.
- If they have convictions about certain types of securities—those considered value or momentum stocks, say—they can employ direct indexing to tilt their allocation to favor those characteristics, or factors.
- Investors aren’t limited to a single benchmark. They can combine multiple reference benchmarks to achieve the precise exposure they seek.
In other words, direct indexing takes the one-size-fits-all approach of commingled investing and turns it on its head, helping advisors add compelling value to a passive portfolio and tailor it to each individual client’s circumstances and values. What’s more, direct indexing’s direct ownership of individual securities offers powerful flexibility around charitable giving and estate planning. And direct indexing isn’t limited to equities. You can build a direct indexing custom SMA using fixed income too.
Does all this customization mean direct indexing isn’t truly a passive form of investing? Some subscribe to this point of view, arguing that direct indexing is instead a unique form of active investing. A reasonable position. But regardless of what we call it, it’s clear that investors are increasingly seeking a way of capturing market-like (or beta) returns on their own terms—an index of sorts that they can build and control.
What is tax-loss harvesting, and why is it such an important part of direct indexing?
Losses aren’t the goal of any portfolio, and investors generally don’t like to see them in their monthly statements. However, in a broadly diversified allocation to stocks or bonds, they’re inevitable. Even during periods when the broad market and many individual stocks rise in value, quite a few others fall. Below is an example from 2020, using the S&P 500® Index as a benchmark.
S&P 500® Index performance in 2020
Source: FactSet, 12/31/2020. For illustrative purposes only. It is not possible to invest directly in an index. Not a recommendation to buy or sell any security. Past performance is not indicative of future results.
Overall, 2020 was a good year for equities. Despite the COVID-19 pandemic and the market volatility it generated in the first half of the year, the S&P 500® rose more than 18% for the year. But as you can see from the chart, 196 names in the index showed a loss for the year. If you were an index fund investor in 2020, you couldn’t use those losses to offset capital gains elsewhere in your holdings because you couldn’t access them. They were locked in the fund, and if you sold shares in the fund you’d be on the hook for any required capital gains taxes resulting from that fund unit sale.
However, as I touched on above, when investors own securities directly as opposed to owning them indirectly, via shares in a fund, it means they can put those individual losses to work. The SMA portfolio manager can harvest a loss in a given security, the investor can bank the loss to use in the current or a future tax year, then the manager can reinvest the sale proceeds in a similar security (while taking care to avoid IRS wash-sale rules) to preserve the investor’s exposure and risk-return profile.
We think a lot about taxes because investors think a lot about taxes. But one thing many investors and their advisors may not be aware of is that taxes can be a bigger drag on portfolio performance than fees or trading costs. That’s why we don’t wait for the end of the year to begin harvesting losses. To make sure our clients aren’t missing out on opportunities, we harvest losses systematically, throughout the year. Third-party research has shown that tax management can add 1%–2% in after-tax excess returns.*
Is direct indexing right for all investors?
Direct indexing’s benefits can vary depending on an investor’s profile, but the types of investors who may see the greatest value from it include those who:
- Are in a higher tax bracket (may have more taxes to save)
- Have a long-term investment focus (may reap more benefits from tax deferral)
- Express convictions about ESG (may value ESG-related customization)
- Fund a portfolio with existing securities (may see real tax savings as opposed to selling all positions and reinvesting in a commingled fund)
Those whose profiles don’t align with one or more of these traits might not see as many benefits to direct indexing—especially after considering it from a cost perspective. Compared with commingled vehicles such as ETFs, custom passive SMAs have higher fees and added operational complexity.
One other thing to consider with direct indexing: Because it involves customization of the broad market allocation, performance can deviate from that of the investor’s chosen benchmark. This is often referred to as tracking error, and investors seeking to take advantage of direct indexing’s benefits must also be willing to tolerate some carefully managed tracking error.
For all these reasons, many investors who don’t naturally benefit from customization will continue to get market exposure through funds and ETFs. But it’s important to add that funds, ETFs, direct indexing, and even active management aren’t mutually exclusive. All have important roles to play in the investment ecosystem.
The bottom line
Direct indexing is clearly having a moment. Is it poised to disrupt the industry, as some observers believe? Sure, but it’s hard to say to what degree. What seems certain is this: Direct indexing can be a powerful tool to help investors take greater control of their broad market holdings and realize more after-tax value from them. The current hype has been fun to watch, but at Parametric we’re just happy that a strategy we pioneered and refined over the past 30 years is increasingly being “discovered.”
“Russell®” and all Russell index names are trademarks or service marks owned or licensed by Frank Russell Company (Russell) and London Stock Exchange Group plc (LSE Group). This strategy is not sponsored or endorsed by Russell or LSE Group, and they make no representations regarding the content of this material.
* Shomesh E. Chaudhuri, Terence C. Burnham, and Andrew W. Lo. 2020. “An Empirical Evaluation of Tax-Loss-Harvesting Alpha.” Financial Analysts Journal 76:3, 99–108. This study did not involve Parametric or its clients. There is no guarantee that a tax-management strategy will result in increased after-tax returns. Results will differ based on an individual investor’s circumstances.