WTF (What the Finance) is Direct Indexing?

Do you feel like the financial services industry is plotting to sell you yet a new way to invest your money?  Do you wonder if investment companies are constantly looking for a way to make themselves seem smarter than you and justify charging you fees? You are right!


Enter the idea of Direct Indexing.  First, let’s discuss indexing in general.


An index mutual fund (also ETF) is an investment product that puts your money in an established list of stocks or bonds.  For example, the Vanguard 500 Index invests money in the S&P 500 index of the 500 largest US stocks.


There is not a manger or team of analysts deciding if these stocks have growth potential or face large risks in the short term.  Index funds are managed by a computer.  For this reason, they are inexpensive to own (low annual expense ratios) and considered tax-efficient (very little internal trading).


What, then, is Direct Investing?  Instead of buying one mutual fund that replicates the S&P 500, you would buy the 500 stocks individually yourself and rebalance them regularly to stay close to replicating the benchmark index.  What could possibly go wrong?


In the past, only the very wealthy could attempt direct indexing.  You’d need enough money to buy at least one each of 500 stocks (in the example we are using – there are many types of indices).  Then, you need to make sure your line up is weighted like that of the index.


Back in the day, you would also pay the stock trading fees for all of the transactions needed to create and maintain your personal index.  These days, with many brokers offering no-cost stock trades, that expense has gone away, making it possibly more interesting to do Direct Indexing.  Also, there is now the ability to buy partial shares of individual stocks (a newer development) so you don’t have to be uber-wealthy to employ this strategy.


The advantage to doing all this work seems to be the ability to control your investment tax bill with pinpoint tax loss harvesting that is catered to your account only.  There is also the ability to “customize” but then that seems defeat the whole idea of indexing.


Direct Investing appears to be a ton of work without major benefits to the average investor.  Just because it has become more available to the non-billionaire recently doesn’t mean it’s necessary.



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