Retirement Weekly: What is direct indexing?
Not everyone is built to be their own money manager, which is why many investors choose a more hands-off approach that we in the financial industry call passive investing.
But don’t let the name fool you—taking a passive investing approach doesn’t mean being passive about your financial future. Instead, it refers to a specific strategy where, rather than trying to exceed the market’s performance, you look to match the same returns of a market index like the S&P 500 SPX,
Passive investing has become an increasingly popular way to invest because it can be cheaper than paying someone else to manage your investments for you. Many passive investors buy shares in exchange-traded funds (ETFs) and mutual funds that are designed to mirror market benchmarks, simply looking to “go with the flow” of the markets.
While ETF and mutual funds provide an efficient means for passive investing, investors can potentially enhance a passive strategy through direct indexing. Similar to an index-tracking ETF or mutual fund, direct indexing strategies look to deliver the pretax returns of an equity index. Instead of a commingled vehicle, asset managers carry out direct indexing on your behalf by taking positions in a representative sample of underlying index constituents. This approach offers flexibility for customization, including which index to track and exposures to avoid or feature, and possible tax advantages.
In other words, this allows you to choose the actual ingredients and directly own the underlying equities in your basket, rather than buying a pie that someone else baked. But how does direct indexing help, and how can you know if it might be right for you?
A more active passive approach
While direct indexing is still mostly used by high-net-worth individuals, it’s becoming more popular and more accessible to everyone.
You can take part in direct indexing through a direct indexing separately managed account (SMA) manager. Typically, most investors choose an off-the-shelf index such as the S&P 500 index, but the strategies do typically lend themselves to customization—including selecting an existing index or seeking to accentuate or avoid certain exposures. It’s helpful to work with a financial adviser with direct indexing, since this strategy will need to be deployed in advisory programs.
Direct indexing offers some compelling advantages over other forms of passive investing:
- Tackling taxes. Our research shows that the systematic, year-round tax management provided through direct indexing may add up to 2% in annual after-tax excess returns. Direct indexing can also become a vehicle for tax-loss harvesting, charitable giving flexibility, holding period management, or gain-realization deferral. These tax savings can help soften the impact of market volatility and offset realized capital gains from other investment strategies, including active managers. Make sure to talk with your tax professional about the choices available to you and how direct indexing might play a part.
- Customizing based on your values. Since direct indexing allows you to customize your investment exposures, it can be especially useful if you care about giving priority to your values. For example, direct indexing can deploy environmental, social, and governance (ESG) and other value-based screens, like gender equality, racial justice, or religious values. And what if you simply do not want to invest in a company for any reason at all? You can factor those out too.
- Customizing your strategy. Another lesser-known customization of direct indexing is the ability to utilize less common indexes or design your own custom solution by combining multiple benchmarks to create something entirely your own. If you receive equity compensation from your employer or own a large concentration of a particular company’s stock, direct indexing can also offer a path for you to diversify and balance against that concentration risk.
Keeping your eyes open
Of course, there are two sides to every coin. Passive investing in general—and direct indexing in particular—may not necessarily be the best choice for everyone, and it’s important to think through all your financial goals before getting started.
More specifically, direct indexing may be most prudent for those who have a large amount to invest in a taxable account and desire a high level of customization they can’t get anywhere else.
Owning your financial future is important—so it’s important to connect with trusted tax and financial professionals before you dive into direct indexing (or any strategy for that matter). As more people recognize the opportunities inherent in direct indexing, it may be worth looking into this strategy, and how it can play a part in your own financial journey.
Steve Edwards is Managing Director, Morgan Stanley Wealth Management Global Investment Office.
This material has been prepared for informational purposes only. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley Smith Barney LLC (“Morgan Stanley”) recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Morgan Stanley Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
S&P 500 index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market.
Indices are unmanaged. An investor cannot invest directly in an index. Performance of indices may be more or less volatile than any investment product. The risk of loss in value of a specific investment is not the same as the risk of loss in a broad market index. Therefore, the historical returns of an index will not be the same as the historical returns of a particular investment an investor selects. Past performance does not guarantee future results.
Direct indexing may only be appropriate for people who have a considerable amount to invest in a taxable account and want a level of customization they couldn’t otherwise obtain through a portfolio of funds or individual securities. If you invest in a tax-deferred account, such as a 401(k) or IRA, the tax-harvesting benefits of direct indexing may provide no additional benefit to you. There is no guarantee that you will maximize value by tax-loss selling; holding on to slumping stock may have resulted in value greater than that obtained through tax-loss harvesting via direct indexing. In addition you will incur asset-based fees and expenses in a direct indexing account that may be higher than those for other investments, as well as transaction costs arising from customization and frequent rebalancing.
An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock prices. The investment return and principal value of ETF investments will fluctuate, so that an investor’s ETF shares, if or when sold, may be worth more or less than the original cost.
Investors should carefully consider the investment objectives, risks, charges and expenses of an exchange-traded fund (ETF) or mutual fund before investing. The prospectus contains this and other information about the (ETF) or mutual fund. To obtain a prospectus, contact your Financial Advisor or visit the (ETF) or mutual-fund company’s website. Please read the prospectus carefully before investing.
The returns on a portfolio consisting primarily of environmental, social and governance (ESG), diversity equity and inclusion (DEI), racial justice or faith-based investments may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG, DEI, racial justice and faith-based criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. Diversification does not guarantee a profit or protect against a loss in declining financial markets.
Morgan Stanley Smith Barney LLC (“Morgan Stanley”) and its Financial Advisors and Private Wealth Advisors do not provide any tax/legal advice. Individuals are urged to consult their personal tax or legal advisers to understand the tax and legal consequences of any actions, including any implementation of any strategies or investments described herein and before making any tax or legal-related investment decisions.
© 2022 Morgan Stanley Smith Barney LLC. Member SIPC. CRC 4676317 09/22