As if we didn’t already have enough investment strategies to choose from, a (sort of) new one has been receiving extra attention lately: direct indexing. If you’ve read about it, you may be wondering what it is, how it works, and whether it’s worth using for your own investments.

Before you decide to jump on this or any other investment bandwagon, we recommend weighing the advantages and disadvantages involved. Once you do, you are likely to find other, preferred ways to invest toward your personal financial goals.

But first things first …

Direct index investing shares some traits with its more familiar cousin, index fund investing. A traditional index mutual fund or exchange-traded fund (ETF) buys and holds the securities tracked by a particular index, which in turn seeks to replicate the performance of a particular slice of the market.[1] For example, the Vanguard S&P 500 ETF (VOO) tracks the S&P 500 Index, which approximately tracks the asset class of U.S. large-company stocks.

In direct indexing, you invest directly in most or all of the securities tracked by an index, instead of investing in an index fund that invests in them for you.

Let’s say you have $100,000 you’d like to allocate to the asset class of U.S. large-company stocks, as proxied by the S&P 500. Here’s how you or your investment manager might proceed:

 

As an Index Fund Investor …

As a Direct Indexing Investor …

As an Index Fund Investor … You could buy $100,000 worth of an S&P 500 Index fund, weighted by market-cap. You would then indirectly hold all U.S. large-company stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index.

As a Direct Indexing Investor … You could achieve the same exposure to the same collection of U.S. large-cap growth stocks by investing $100,000 directly in the individual stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index.

As an Index Fund Investor … In your account statements, you would see a single position in one fund representing a U.S. large-cap stock allocation (as proxied by the S&P 500). To hold a larger or smaller allocation to this asset class, you would buy or sell shares of this single fund.

As a Direct Indexing Investor … In your account statements, you would see hundreds of different stock positions (or at least enough stocks to accurately emulate the index). [2] You could then individually buy or sell shares from each position to alter your U.S. large-cap stock allocation.

As an Index Fund Investor … When the S&P 500’s holdings or weights changed in the index, the fund would alter its underlying holdings as well. To continue tracking the index, you simply keep holding the fund.

As a Direct Indexing Investor … When the S&P 500’s holdings or weights changed in the index, you would need to place trades across your individual positions to continue tracking the index.

As an Index Fund Investor … When selling fund shares, you’d realize a gain or loss based on how much you paid for each mutual fund or ETF share.

As a Direct Indexing Investor … When selling individual stock shares, you’d realize a gain or loss based on how much you paid for each stock share.

Direct indexing doesn’t have to be an “all or nothing” strategy. It’s more typical to implement it for the portion of the portfolio allocated to highly liquid asset classes, such as U.S. large-cap stocks, where it’s easier to routinely buy and sell components. Direct indexing becomes increasingly impractical in markets where trading is more difficult and/or expensive.

Some institutional and similar large investors have been incorporating direct indexing into their portfolio builds for years, usually through Separately Management Accounts (SMAs). As such, the approach is not new, but it has been receiving increased media coverage lately.

That’s likely because direct indexing has become more practical for individual investors. Recently, many trading platforms have: (1) eliminated investor trading fees that made it cost-prohibitive to buy and sell so many individual securities; and (2) allowed fractional share purchases, making it possible to capture an index’s holdings in smaller slices. As a result, more providers are offering direct indexing services to smaller accounts for relatively modest fees.

Even if it’s possible to engage in direct indexing at costs approaching those of traditional index fund fees, why not simply go along for the low-cost index fund ride? The potentials are two-fold:

Direct indexing may offer more granular portfolio and tax management than you can get through traditional index fund investing. But any incremental benefits must be weighed against the tradeoffs involved in implementing them. We also must determine not only whether direct indexing may be an acceptable solution, but whether it’s the best one available.

On both counts, we’re not as enthused by direct indexing as we are by our current funds-based approach to helping investors achieve their long-term financial goals.

Our concerns can be captured in a word: stamina. Your ideal investment portfolio must not only start strong, it must be built to last. In our next piece, we’ll take a closer look at why we’re not yet convinced direct indexing is the best solution for that challenge.

[1] As index investing has proliferated, so have more exotic indexes, tracking trends such as fine wine or Canadian cannabis. For our purposes, we are referring to traditional indexes, tracking broadly recognized market asset classes.

[2] One proponent of direct indexing suggests: “[Y]ou can capture the vast majority of diversification benefits of the S&P 500 by owning the largest 100 stocks in the S&P 500 Index.”