by Kevin Knowles & Michael McAleer, Russell Investments
The term direct indexing is somewhat of a misnomer. After all, as we are regularly reminded by compliance, you can’t invest directly in an index. So what is direct indexing and why has it become so popular?
In its simplest form, direct indexing involves directly investing in the actual securities that make up an index. This is different from investing in exchange-traded funds (ETFs) that track an index or mutual funds that follow a benchmark index. Mutual funds and ETFs are commingled funds: they package underlying securities into a single vehicle that investors can buy but not modify. Everyone who buys that mutual fund or ETF gets the same combination of securities. In other words, one size fits all.
Direct indexing, on the other hand, allows investors to own the securities that make up an index and hold them in a separately managed account (SMA). This gives the investor the same market exposure as the index but also gives them the opportunity to build a customized portfolio. The investor can exclude certain securities or increase their exposure to others to reflect their specific goals, needs, or circumstances.
This type of investing has long been available to high net-worth and institutional investors. However, due to a wave of acquisitions and the launch of proprietary solutions from a variety of asset managers, this product has recently become more widely available to retail clients.
Since most retail investors don’t usually have the funds to buy all of the securities that make up an index, providers of direct indexing products use sampling. Sampling is the practice of reducing the number of securities purchased but keeping the overall portfolio exposures in line to mimic the entire index. This has made direct indexing more accessible to a broader range of investors.
Direct indexing is expected to grow at an annualized rate of more than 12% over the next five years¹, according to a recent report by Cerulli Associates. The report also noted that direct indexing assets claimed nearly one-fifth of the industry’s total retail separate account assets in 2020, reaching $362 billion in assets.
As investors become more sophisticated and knowledgeable, and as their needs become more complex, direct indexing can help advisors offer investors far more options than ever before. Think about your clients: some are more tax-sensitive than others, some have strong environmental, social and governance (ESG) preferences and others don’t, some want to avoid investing in certain industries for specific reasons. Some want to gain extra exposure to certain industries to express their belief in a theme or trend. With direct indexing, meeting those client needs is possible.
Why use direct indexing?
There are a lot of benefits to owning the actual securities directly instead of a packaged vehicle like a mutual fund or ETF. When you buy a packaged or commingled vehicle, not only are you unable to customize or personalize your exposures, you are beholden to actions taken within the fund that could have implications for you. For example, if the fund sells securities throughout the year, the fund company is required by law to distribute the gains to all shareholders in that year. Common in active funds as managers sell positions to take gains, these capital gains distributions have been a thorn in investors’ sides for years. To make matters worse, if there are net losses in the fund, not only are fund managers not required to distribute them, but they’re also not allowed to distribute them.
Advantages of direct indexing
In comes direct indexing. When an individual owns securities and then sells them, this action either generates a capital gain or a capital loss. When shares are sold at a gain, an individual must realize those gains that year. Active SMAs can often run into a problem because any turnover or selling done by the manager results in a capital gain for the investor. The more turnover there is, the more likely there is to be capital gains generated that the investor must pay taxes on in that year. With direct indexing, any capital losses can be used to offset capital gains at the household level. In other words, gains in the portfolio can be offset but so can gains in other portions of an individual’s overall portfolio. This can greatly help to reduce the capital gains distributions that so often result in a significant tax liability.
Since the objective of direct indexing is to track a particular index, and indexes have no turnover outside of reconstitution, the manager does not have to sell anything. Instead, the manager can strategically sell losing positions, replace those positions with other securities to maintain close tracking with the index and realize a LOSS. This means that when the investor does their taxes, they will have these net losses that can either be used to offset gains in another part of their overall portfolio or carried forward to be used in future years (up to $3,000 in net losses can be used in the current tax year while any excess amount can be carried forward).
Is direct indexing suitable for all investors?
The advantages of direct indexing to an individual investor can vary depending on that investor’s goals, needs and circumstances. The types of investors who would most benefit from direct indexing include:
- The tax-sensitive investor
- The investor with a longer time horizon who may benefit from deferring capital gains
- The investor with a firm conviction on ESG or other themes and wants to reflect that throughout their portfolio
- The investor who currently directly owns securities and would like to move them to a more tax-efficient portfolio
Advisors should also be aware that investors who closely follow benchmark performance may not find direct indexing to their liking. Because of the ability to customize exposures, using direct indexing in a SMA will result in performance that deviates from the index. Be sure your investors are able to tolerate some tracking error when recommending a direct indexing strategy.
The bottom line
Given our passion and heritage for tax management at Russell Investments, we tend to focus on taxes but there are a lot of other personalization benefits to direct indexing such as the ability to express ESG preferences, restricting securities and efficient charitable giving. Direct indexing can also be combined with active management to create a single custom SMA. Having both direct indexing and active strategies gives advisors optionality for different client needs. We will discuss these in future posts.
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