The Drawbacks of Direct Indexing

Like most investment strategies, direct indexing has drawbacks as well as benefits, but the benefits get the most attention.

The strategy involves individual securities owned in aggregate to resemble an index, but unlike an index ETF or mutual fund it allows for tax loss harvesting on a security-by-security basis, which can lead to greater savings. It also provides for greater customization of asset holdings,  letting investors exclude, underweight or overweight individual assets to better reflect their preferences, including those related to combating climate change or stressing factors like value or momentum.

Direct indexing “is a capability; it’s a way of building a portfolio that meets very specific needs of individual investors that more often than not starts with an index,” explained Ben Johnson, director of global exchange-traded fund research at Morningstar in a recent  Q&A on Morningstar.com.

But direct indexing also has drawbacks and limitations. For starters, it makes sense only for taxable accounts, since tax-loss harvesting is one of its key benefits, and is often available to those accounts held by high-net-worth or ultra-high net worth clients. Most strategies have a $250,000 or $500,000 minimum, as do most separately managed accounts (SMAs).

In addition, at some point the portfolio has no more assets to sell to realize losses to offset capital gains for tax purposes.  It becomes “locked up,” and no longer generates the “tax alpha” it was designed for, according to Johnson.

A direct indexing portfolio is also more costly to build than a portfolio of broadly diversified ETFs due to fees and trading costs and potential opportunity costs. Johnson explained that with direct indexing an advisor or investor essentially becomes a discretionary stock picker whose customized portfolio may or may not yield better risk-adjusted returns than a diversified portfolio of index funds.

Direct investing “makes a large number of investors effectively active managers,” said Johnson. “Sometimes it’s going to look right and feel good, and sometimes it’s going to look wrong and feel bad. That goodness or badness could be an opportunity cost to investors.” In some cases they might be better off owning a portfolio of broad-based index mutual funds or ETFs.

The Outlook for Direct Indexing

Nonetheless, Johnson expects direct indexing will become more available over time given the acquisitions of direct indexing firms by major asset managers. Over the past year or so, Schwab acquired Motif; BlackRock purchased Aperio; Morgan Stanley bought Eaton Vance, which owns Parametric; and, most recently, Vanguard announced a definitive agreement to acquire Just Invest.

Johnson expects to see efforts to extend the investment strategy that has historically been “the reserve of high-net-worth and ultra-high-net worth individuals” to “a larger audience” of investors over time, including smaller investors. Cerulli Associates is projecting that the annual growth rate for direct indexing over the next five years will surpass that of ETFs and mutual funds.