Direct Indexing Offers Investors Greater Choice Than Inflexible ETFs
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Direct Indexing Offers Investors Greater Choice Than Inflexible ETFs

Direct indexing assets could reach a $1.5 trillion market share of AUMs by 2025.
Neither the author, Tim Fries, nor this website, The Tokenist, provide financial advice. Please consult our website policy prior to making financial decisions.

Owing to their near-zero fees, exchange-traded funds (ETFs) have become popular not only in the stock market but in the crypto sector as well. For most retail investors, ETFs provide a simple and effective investment vehicle.

ETFs’ Popularity Comes with Limits

By investing in a blue-chip S&P 500 index, traders gain exposure to the biggest market cap stocks around: Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), and Meta (FB), to name a few. However, although ETFs diversify portfolios they also present problems.

Stocks are not owned directly with ETF holdings, excluding shareholders from the perks of direct ownership such as dividend payouts and voting rights for board members. Most crucially, because ETFs offer bundled stocks, you can’t reduce your exposure to individual stocks.

For instance, if you think that Tesla (TSLA) is overvalued, and want to exit the exposure, an index fund won’t be up to the task. This is where direct indexing comes in, allowing direct ownership of stocks within the index.

Why Hasn’t Direct Indexing Been More Popular Before?

Direct indexing means investors can customize their own stock portfolio instead of relying on an ETF bundle of stocks. To make that happen though, they would have to buy individual stocks, including the pricey blue-chip ones.

Thanks to zero-commission trading, first introduced by Robinhood and then widely accepted by other brokers, direct indexing has become more viable. Furthermore, due to fractional stock investing, one no longer has to buy an entire stock share.  These two ingredients have made direct indexing on the rise, as a viable investing solution to inflexible ETFs.

Up until recently, direct indexing was reserved for large institutional clients and the ultra-rich who could have afforded to pay for up to 0.3% of asset fees to maintain such a customized portfolio. For instance, in our Wealthfront robo advisor review, the company charges 0.25% of assets fee for direct indexing under tax-loss harvesting.

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The Benefits of Direct Indexing

Now that fractional stocks and zero-fees have made inroads, more companies are offering direct investing. One of them is O’Shaughnessy Asset Management (OSAM) with their Canvas portfolio customization. Having been acquired by Franklin Templeton, a $1.5 trillion global asset manager, it was the Custom Indexing platform that made OSAM an attractive acquisition target.

Likewise, the world’s largest asset manager, BlackRock, completed an acquisition of Aperio for $1 billion in February, which had pioneered custom index equity portfolios.

Because investors can ditch stocks they don’t want in their index, this translates to lowering their tax burden, as explained in this tax-loss harvesting guide. Selling unwanted stocks has an additional perk for investors that place value in ESG (Environmental, Social, and Governance) objectives. Investors gain flexibility and can avoid companies they don’t like, such as oil companies, while supporting those that are making a concerted effort to go green, as just one example.

Custom Funds Challenges

In every 101 investment class, it is commonly taught that benchmarked investing beats active stockpicking. Most notably, in their book “The Incredible Shrinking Alpha“, Andrew Berkin and Larry Swedroe, the chief research officer at Buckingham Wealth Partners, have made a solid case that active portfolio managers underperform risk-adjusted ETFs. Specifically, after 15 years, 92% of large-cap funds are lagging behind the S&P 500 index.

However, one has to consider the power of social media and group thinking. For example, QuiverQuant, the alternative platform that leverages big data to track the trades of lawmakers and their spouses, allows one to filter their buys and sells by specific lawmakers. In effect, this can create a pipeline from politicians’ insider trading knowledge to retail investors, although some of this knowledge comes with a delay.

Combined with the efforts of social media platforms like Reddit’s /WallStreetBets, which accumulates and filters trading tactics, we may be looking at an upturn of trends. Ones in which the greater flexibility of direct indexing ends up beating the benchmarked market. In turn, this could lead to redefining the criteria for being listed in big traditional indexes like the S&P 500.

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Do you think relying on online guidance would compensate for intimidating custom fund-building? Let us know in the comments below.

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