Direct indexing is the hot new investing strategy. What you need to know

• Direct indexing, which allows investors to buy the stocks of an index, instead of purchasing a mutual or exchange-traded fund, may soon become more widely available.
• This strategy may appeal to those seeking portfolio customization or tax-saving opportunities.
• However, the technique won’t work for all investors, financial experts say.

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Direct indexing, which allows investors to buy the stocks of an index, instead of purchasing a mutual or exchange-traded fund, may soon be available to more investors.

While ultra-high-net-worth people have historically used the strategy, those with fewer assets may soon have access as more financial services companies double down on these solutions. 

For example, Vanguard last month acquired Just Invest, a direct indexing company. BlackRock has also made investments, acquiring Aperio in 2020 and recently buying a minoring stake in SpiderRock Advisors. 

Moreover, Morgan Stanley joined the game last year when it acquired Eaton Vance, parent company of custom indexer Parametric.

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"People want a little more control over what they're investing in," said certified financial planner Michael Whitman, managing partner at Millennium Planning in Pittsboro, North Carolina. "And when you buy into a mutual fund or ETF, you're at the mercy of the manager."

Here's how it works: After picking an index to track, financial advisors buy a representative share of the index's stocks and manage those assets by rebalancing the portfolio over time. These holdings are typically in a taxable brokerage account.

Direct indexing generally works best for bigger portfolios because it may be costly to own an entire index. However, this barrier may shift as more brokers offer so-called fractional trading, allowing investors to buy partial shares. 

"You've got to have at least $80,000 to $100,000 for it to make sense," Whitman added.  

For example, an advisor may purchase 150 to 200 equities to track the S&P 500, said Ken Nuttall, CFP and chief investment officer at BlackDiamond Wealth in West Grove, Pennsylvania. 

"The beauty is that not every stock goes up," he said. As some go down, advisors may sell certain stocks at a loss to help offset the portfolio's overall gains, a tactic called tax-loss harvesting. Advisors may rebalance monthly, quarterly or more often during volatile periods.

Almost half of actively managed accounts don't receive any tax treatment, according to a Cerulli report. However, financial experts say direct indexing may offer so-called tax alpha, which provides higher returns through tax-saving techniques. 

However, as direct indexing is an active strategy, it is more costly than owning passively managed assets, such as index funds and ETFs.

While the average fee for passive funds is 0.13%, as of 2019, according to Morningstar, the cost for direct indexing may be closer to 0.30% to 0.40%, Whitman said. 

Yet the expense may be worth it for those seeking more flexibility and tax savings, particularly with the looming threat of President Joe Biden's proposed capital gains tax hikes. 

Portfolio customization

Direct indexing may also appeal to those looking for more portfolio customization, such as value-based investors who want to divest from specific sectors, said Charles Sachs, CFP and chief investment officer at Kaufman Rossin Wealth in Miami. 

"It's a great way to be able to tilt your portfolios to causes that you believe in," he said. 

Portfolio customization may also be handy for someone with many shares of a single stock.

For example, an Apple or Amazon executive may want to diversify by investing in an index without their company holdings. Direct indexing may allow them to cherry-pick their stocks, he said.

While direct indexing may appeal to those seeking more control, experts say it may be too difficult for do-it-yourself investors. 

"It's almost impossible to go to a brokerage account and buy 100 to 150 stocks and know what you're doing," said Whitman. Those considering the strategy need to discuss the pros and cons with a trusted financial advisor.

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