Direct Indexing is gaining traction as an attractive equity investment alternative to many different types of investors, beyond the traditional large institutional class. Direct Indexing is simple, cost-efficient and offers exceptional flexibility compared to ETFs.

What’s Direct Indexing? Here is how I see it, in a nutshell:

  • The investor gains direct exposure to a single Index or a blend of indices or/Factor strategies, through direct stock holdings in a Separately-Managed Account (SMA).
  • Implementation through an SMA opens up benefits around tax management and customization, while simultaneously tracking a chosen index (‘tightness’ of tracking can vary based on the level of customization desired). Effective tax management adds after-tax returns, while individualized customization allows for investors to align themselves with socially responsible investing goals, or build around legacy stock holdings.
  • Moreover, compared to a traditional SMA, Direct Indexing is cost-efficient for small account sizes, starting at $100,000. Optimal has developed direct back-end integration with its custodian, and utilizes fractional share technology to allow for holdings of hundreds of stocks.

You may be surprised to hear that, for all these additional benefits, SMA management fees are in-line with, or lower than, holding comparable factor ETFs!

In short, through Direct Indexing, the investor holds the underlying stocks directly, and at ETF-like fee levels.

 

Direct Indexing Motivation #1: Tame your Tax bill

For a typical US high-net worth investor, tax-loss harvesting has been estimated to range, on average, between 1.5% – 2.5% annually for a typical SMA, relative to an ETF.

In addition to the benefits offered by tax-loss harvesting, Optimal’s strategies are designed to make long-term holdings the standard, and short-term sales the exception. This focus on realizing (lower) long-term gains rates and not incurring (higher) ordinary income rates is another key feature of Optimal’s tax-management strategy. 

 

Tax-Management Use Case 

An investor selects an index (or combination of indices) that provides the desired exposure; for example, the S&P 500 Low Volatility index. Now assume that the investor would like to use individual stock losses in the stock SMA to offset gains from a profitable real estate sale.

Based on the investor’s circumstances, and subject to tax advice (which Optimal does not offer), the investor and Optimal can decide whether to apply tax-loss harvesting, and/or a tax deferral overlay.

Despite the index having risen overall since purchase, many stocks might typically have traded down, representing unrealized losses. These stocks can be sold, converting the unrealized losses to realized losses, which can then be used to offset gains from the real estate sale. Optimal then replaces the sold stocks with other comparable stocks to maintain the overall risk/return profile of the S&P 500 Low Volatility index.

 

Direct Indexing Motivation #2: Custom-build your Portfolio

Direct Indexing also makes it possible for an investor to fine-tune, or more broadly alter, the individual stock constituents of an index to better suit their needs.

Socially Responsible Investing (SRI) considerations have advanced to the top of many investors’ agendas. Through Direct Indexing, the investor can adapt an index based on specific, investor-determined environmental, social, or governance policies. In brief, instead of buying an off-the-shelf ETF, or even an SRI-based ETF, Optimal can apply screens specified by the investor. We can also add screens to filter out (or to complement) legacy holdings.

 

Custom-building Use Case: Blending Factors + SRI + Legacy

An investor desires a portfolio that is the intersection of the constituents of the S&P 500 Momentum and the S&P 500 Enhanced Value index (this is a more concentrated portfolio consisting only of stocks that exhibit both factor characteristics, and is therefore unavailable as an ETF or combination of ETFs).

The investor wishes to exclude companies suffering from low scores on labor practices (e.g. as a result of  child labor or human rights violations). SRI ETFs that are available to the investor are standardized to pre-defined policies and screening rules, and there would likely be no ETF available that would fit exactly the desired labor-based exclusions.

The investor decides to also exclude Apple shares from the portfolio, as it has a large legacy position in these shares, which it does not wish to incur heavy capital gains on by selling.

Optimal will manage an SMA for this investor that represents a unique portfolio, with features that together are unavailable in any standardized product in the marketplace:

  1. Intersection of Value and Momentum stocks
  2. Ex-labor-based violators
  3. Ex-Apple legacy holding

 

Conclusions

Advancements in fractional share technology equip investors with a new means to invest small allocation sizes in stocks directly, while at the same time tracking a chosen index. This new development, aka Direct Indexing, allows the investor to stay in control of the assets and provides enormous flexibility to apply custom tax management and stock screens. Direct indexing hands non-institutional investors a powerful new way to gain index-like stock exposure.

 

Teun Lucas is head of sales and client relations at Optimal. Optimal Asset Management is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940, as amended.