What Is direct indexing?

Direct indexing is a way to create a diversified portfolio of individual stocks personalized to meet an investor’s needs, values, and investment preferences.

The first step in creating a direct-indexing portfolio is for the investor to select one or more indexes that their portfolio will be designed to track in consultation with their advisor.

The second step is for the investor, again in consultation with their advisor, to individually customize the portfolio. There are many ways this can be done.

Express values. Investors can screen out companies or industries that engage in activities they don’t support or overweight companies or sectors that engage in activities they support.

Express preferences. Investors can tilt their portfolios toward certain factors or stocks with specific investment characteristics, like quality, momentum, low volatility, or high dividend payments.

Address special needs. Investors can incorporate legacy positions, screen out employer stock, and harvest tax losses to lower their tax bills or maximize the benefits of charitable giving.

Then, based on the investor’s directions, the direct-indexing manager creates a portfolio that closely tracks the selected indexes while reflecting the investor’s customization choices.

Is direct indexing passive or active management?

True index investing – or passive investing – involves investing in mutual funds, exchange traded funds (ETFs), or portfolios of individual securities designed to track an index closely. Passive investing is designed to benefit from diversification and capture the healthy returns that broad market exposure has historically provided to patient long-term investors.

A passively managed portfolio typically contains most, if not all, the securities in the index it tracks. If a stock is in the index, it qualifies to be in the portfolio. A passively managed portfolio may hold hundreds or even thousands of securities.

Unlike a passively managed portfolio, many actively managed portfolios start with nothing. Securities are selected based on research conducted by the active manager. The portfolio is built from the ground up, and each security must earn its place in the portfolio.

Alternatively, an actively managed portfolio may start with a broadly defined universe of securities, like an index, which is then modified to exclude or weight specific securities or security types designed to achieve the portfolio manager’s objectives.

Either way, the active manager’s goal is to create a portfolio of individual securities that will outperform a relevant benchmark, like an index, or achieve specific investment objectives that cannot be achieved at all or by strictly tracking an index.

Since the first step in creating a direct indexing portfolio is the selection of one or more indexes for the portfolio to track, it has characteristics of passive investing. But the typical directindexing portfolio will not hold every stock in the indexes it tracks. Instead, it contains a representative sample allocated by the manager to mirror the industry and sector composition of the indexes.

In addition, the direct-indexing portfolio is customized to meet the investor’s needs, values, and preferences. Depending on the level of customization, the portfolio’s holdings and performance may diverge significantly from the indexes used to establish the baseline portfolio, which gives it characteristics of active management.

Direct indexing is a hybrid form of investing that combines passive and active management elements. But since direct indexing always involves some level of customization and intentional deviation from the index, it is a form of active management.

How “active” should a direct-indexing portfolio be?

We can help select an appropriate index for our clients and, along with our direct-indexing portfolio manager, can provide the following services:

• Assist in developing an asset allocation strategy;
• Assist in the selection and articulation of customization choices;
• Help manage the balance between tracking error and customization;
• Create a portfolio that mirrors the performance of the selected indexes while reflecting your customization choices – this process is sometimes called “optimization”;
• Manage the portfolio following the client’s customization choices while generating potential tax benefits for the client through ongoing tax management

Notably absent from this list is screening the stocks in the portfolio based on the manager’s assessment of their likely future performance. In other words, direct-indexing portfolio managers are not stock pickers. The modifications they make to the indexes they track are based on optimization software, client customization choices, and tax management needs, not the manager’s determination of likely winners and losers.

Are the tax benefits significant?

Managing tax-loss harvesting opportunities can be a time-consuming process. We selected a firm that uses sophisticated algorithms that automatically review each client account daily and harvest individual security losses as opportunities arise. This firm offers one of the only programs to provide a daily automated review of portfolios for tax optimization. It has been found that more frequent tax-loss harvesting reviews lead to higher and more consistent loss harvesting in all volatile environments. These differences can span a wide range, increasing taxalpha^[1] from 20bps to over 100bps annually for an ultra-high-net-worth personalized indexing investor with extensive recurring capital gains.^[2]

Is Direct Indexing right for me?

Every index in any given year will contain some stocks that generate positive returns and some that create negative ones. The presence of winners and losers in an index is to be expected – in fact, it is unavoidable. Every direct-indexing portfolio will contain winners and losers since its composition mirrors the index’s composition.

Historically, broad markets have provided solid returns for investors, even though there are always stocks or industry sectors within those markets that experience negative returns. You don’t need to eliminate the negative performers to benefit from those solid returns.

Second, screening out stocks or sectors based on recent poor performance is unlikely to produce positive investment results. It can often have negative consequences on a portfolio

Finally, here are direct indexing questions to consider:

• Do the potential tax benefits of direct indexing make sense for me?
• How can I design a portfolio to reflect the ESG/SRI issues that matter to me?
• Should I implement a factor tilt (i.e., quality, low volatility, momentum, etc.) to meet specific risk and return objectives?
• Is a direct index strategy more efficient than a portfolio of ETFs and mutual funds?
• Is there a better or more tax-efficient way to manage large existing stock holdings?

[1] Tax alpha: This is a measure of the difference between the portfolio post-tax ending value and the Benchmark post-tax ending value attributable to taxes avoided.

[2] Source: Kevin Khang, Alan Cummings, Thomas Paradise, and Brendan O’Connor, 2022. Personalized indexing: A portfolio construction plan. Valley Forge, Pa: The Vanguard Group

To find out more about direct indexing, please contact your GYL advisor for more information about direct indexing and see if the strategy is right for you.

Disclosures:
Investing involves the risk of loss that clients must be prepared to bear.  There is no specific claim or warranty being implied regarding future performance. Past performance does not guarantee future results.

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