Direct Indexing FAQ

A Q&A on direct indexing

We've compiled a list of frequently asked questions about direct indexes in our Direct Indexing FAQ. Below is an excerpt.

What are direct indexes?

Direct indexes are baskets of securities (e.g. IBM, Ford) that 1) track the performance of an index and 2) are directly (hence the name) owned by investors. Direct indexes stand in contrast to index funds, which also track an index, but don’t provide investors with direct ownership of the underlying securities — instead, the investor owns shares in the fund, which, in turn, directly owns underlying shares.

Do direct indexes track their target indexes as well as index funds?

They can, but direct indexes are usually managed in a way that will cause their returns to depart from those of the underlying index. Sources of return deviation include:

1. Reduced holdings: For convenience or because of small portfolio size, most direct index investors prefer to own baskets with fewer names than are in the index, e.g. 100 stocks that track the S&P 500.
   
2. Customization: Direct index investors have the option to customize their holdings. They can, for example, apply social screens (e.g. “never own tobacco”), or they can work around outside risk exposures (e.g. “don’t own IBM since I’ve already got IBM stock options”).
3. Tax management: Direct indexes can be tax-managed at the tax-lot and security-level. This extra tax management means that direct indexes outperform comparable index funds and ETFs on an after-tax expected basis. But it also means some deviation in pre-tax returns.
4. Smart-beta factor tilts: So-called “smart beta” direct indexing introduces explicit factor tilts, e.g. “momentum tilt”, “yield tilt”. These factor tilts can be used simply to create style-variants of the original index. However, if you periodically update your tilts, you’re basically implementing an active strategy. 
   
   

Most direct indexes really do aim to track, not outperform, their underlying index. And none are traditional “pick winning stocks one-at-a time” actively managed portfolios. On the other hand, they are usually significantly worse than comparable index funds in terms of their tracking error (drift) to the index. 

So, there’s good reason to call them indexes and also good reasons to quibble. But, at the end of the day, the name doesn’t really matter. They’re customized, tax-optimized portfolios of individual securities constructed with an index benchmark as a starting point. 

Why are direct indexes getting lots of attention now?

It’s a combination of an increase in both supply and demand. 

On the demand side, we see greater interest by advisors and investors in tax management, risk customization and impact investing – areas where direct indexing shines. 

On the supply side, there have been multiple technological advances that make direct indexes more affordable and accessible. There’s a back-to-the-future quality to direct indexes. Owning baskets of stocks long predates the invention of the mutual fund or the ETF. Direct indexes themselves have existed for decades. What’s new is that while direct indexes used to make sense only for ultra wealthy investors, they're now affordable and practical for ordinary investors; they can now be offered at a price point that makes them a superior alternative to ETFs for most investors. The technological innovations that have made this possible include:

1. Lower transaction costs: Most major custodians are offering or are planning to offer commission-free trades. This makes a difference. Even a low commission of, say $4.95, means buying a 100 stock direct index would cost investors almost $500. Zero-dollar commissions remove this barrier. Bid/ask spreads are also lower. Large players, like mutual fund companies, used to have a large advantage over individual investors in executing trades at low cost. Now, this is sometimes reversed; individual investors, who don’t need to worry about moving the market, may get better execution than mutual fund companies.
   
2. Rebalancing automation: The tax and customization advantages of direct indexes are impressive, but they’re not automatic. You’ve got to actively manage a direct index portfolio to get tax savings and implement constraints – and do so in a way that keeps the portfolio close to its index benchmark.. Traditionally, this was done somewhat manually by a highly compensated portfolio manager. But with sophisticated rebalancing systems, these tasks can now be automated.
   
3. Fractional shares: For portfolios smaller than $50,000, the need to buy whole shares can distort direct index portfolios, resulting in excess tracking error to the index benchmark. Multiple brokers offer fractional-share trading, making it technically feasible to manage and rebalance direct index portfolios for investors with as little as $50.