Direct Indexing’s Many Uses

The customization and control offered by direct indexing provides solutions for many client needs.

For years, institutions have been able to use customized strategies, with their large pools of assets allowing them to gain access to separately managed accounts that could be tweaked to their specific and unique needs. This type of customization, now referred to as direct or custom indexing, is quickly becoming available to smaller investors.  

Similarly to how the ETF wrapper helped to democratize access to parts of the market that were previously unavailable, technological advancements that have resulted in lower commissions and the trading of fractional shares are providing access to direct indexing for a noninstitutional investor base.

Victor Gomez, CEO and co-founder of BITA, an indexing provider that focuses on custom indexing solutions, outlined the main use cases for the technology.

“There are a lot of cases where the end investor needs customization, because of tax reasons, but also [if they] want to invest given a set of values,” he explained. “You will not always be able to go out to the ETF market to find exactly the product that will allow you to do that.

“And there are many cases of investors that, for compliance reasons, need to do specific exclusions,” Gomez added. “I think that while direct indexing might not be the ETF killer, I do think that there are specific cases where there’s value for this.”

Managing Single-Stock Exposure

A rather straightforward use case would involve excluding specific positions held within an index. For investors who don’t want to or can’t invest in a specific company’s stock, this might be an attractive option.

Consider an investor who is unable to hold Microsoft stock to follow her employer’s compliance policies. Holding a cap-weighted ETF like the SPDR S&P 500 ETF Trust (SPY) wouldn’t be appropriate for this investor.

Courtesy of FactSet

And while the Arrow Reverse Cap 500 ETF (YPS)—which weights holdings inversely to market cap, has minimal exposure to this holding—the fund would be tilted toward smaller cap companies, which might not be desirable to the investor.

Courtesy of FactSet

Direct indexing would allow for a simple solution to this problem. The investor could simply gain exposure to the S&P 500 Index, excluding Microsoft, with no changes to the weighting of other holdings other than rescaling to account for the stock’s exclusion.

Achieving Tax Alpha

Since direct indexing allows the investor to hold the individual securities within the index, it also allows for a greater level of tax optimization due to the ability to tax-loss-harvest these holdings.

While ETFs may also be sold to harvest losses, selling the ETF could mean temporarily forgoing the allocation to the asset class as a whole. Due to wash sale rules, U.S. investors are not able to buy a “substantially identical” security within 30 days before or after the sale at a loss or else the loss is disallowed.

This rule was put into place to prevent people from selling securities solely to generate losses to offset taxable income. The investor is able to buy back in after 30 days without violating the wash sale rule.

While tax law does not define “substantially identical security,” ETFs that track the same index would probably fall into this category.

By using direct indexing, individual securities can be sold to offset any gains within the portfolio, while the remainder of the securities in the index are still held within the portfolio. Sold positions could even be temporarily replaced with an ETF tracking the relevant sector.

Investors need to keep the big picture in mind, however.

“Sometimes the tax optimization will lead you to a portfolio that is completely different from what you wanted to achieve in the first place,” said Gomez.

But for those who do make use of this benefit, research has estimated the value of this tax alpha at 0.85% even when constrained by the wash sale rule.

While the exact value of this tax alpha will be different from year to year and from investor to investor, this estimate puts the added value above the additional fee incurred by direct indexing itself.

Getting Personal With ESG

ETFs that reflect environmental, social and governance (ESG) values have become increasingly popular. In the U.S., one-third of assets invested in socially responsible ETFs are held within three ETFs within the iShares ESG Aware suite.

These ETFs use a basic set of negative screens, excluding companies such as those classified as producers of civilian firearms and tobacco, or others that derive more than 5% of their revenue from oil sands extraction or the mining of thermal coal.

As popular as these ETFs have been, some investors might find that their needs are not met by these ETFs. Even more nuanced takes on socially responsible investing might not be in alignment with an investor’s views due to the personal and unique nature of how each investor views ESG.

In addition, investor surveys have shown that the lack of a clear definition of ESG remains a hurdle for greater adoption within portfolios in spite of interest. By being able to define the investment for themselves, more investors might be inclined to incorporate these types of views within their portfolio.

Amrita Nandakumar, president of Vident Investment Advisory, agrees that ESG investing is a natural fit for direct indexing.

“There are people who would like to include exposure to certain types of industries and definitely exclude others,” she explained. “Why not give investors the opportunity to customize that exposure based on their core beliefs?”

Highlighting ESG’s growing importance to investors, Nandakumar added: “That’s never been more relevant than today, because investors are more and more passionate about where their money goes, and they don’t want to support companies whose missions or activities they don’t support and believe in. They don’t want [exposure] even if it’s inclusion in a broad diversified fund.”

While broad diversified funds will still be the best option for many, direct indexing holds value as a tool for investors with greater customization needs that are not met by ETFs.

Contact Jessica Ferringer at [email protected] or follow her on Twitter