Direct Indexing

Direct indexing: a tool for ESG and philanthropy

Direct indexing has generated a tremendous amount of interest with advisors. A number of large firms, including Vanguard, have completed acquisitions of direct indexing firms, and major custodians have announced plans to offer direct indexing.

Let’s talk about what direct indexing is and whether it makes sense for your clients. Simply put, direct indexing is a move away from commingled funds to direct ownership of stocks in an investor’s account. The term refers to direct ownership and to the fact that the strategies are passive and track a broad index. Advances in technology allow index performance to be closely tracked with only a subset of constituents. Because the investor owns these stocks individually, they can customize this portfolio, including the expression of financial and environmental, social, and governance (ESG) preferences in ways not possible with mutual funds or ETFs.

Financially, there are several benefits to this approach, particularly tax-loss harvesting (because stocks are owned individually and realized losses can be used to reduce taxes) and the opportunity to tilt toward investment themes such as growth or value. Similarly, direct indexing offers an array of benefits for ESG investing.

Direct indexing for ESG?

There are already many ESG-themed funds and ETFs, so what does direct indexing have to offer investors? A surprising number of benefits: increased transparency, customization, the ability to address multiple ESG areas simultaneously, flexibility, and a choice on shareholder voting, to name but a few.

ESG funds tend to either target generalized ESG scores—which can be hard to understand in terms of impact—or to focus on one specific theme. For example, one fund might emphasize diversity in hiring, while another might emphasize environmental compliance. Choosing an ESG ETF means combing through different definitions, strategies, and implementations of ESG that can be hard to compare. An investor could have to split money between funds or choose a general ESG fund that doesn’t focus on the areas the investor wants to focus on. While tailoring solutions is doable, research and manager selection can be daunting for advisor or client.

Direct indexing can address these issues. Investors apply ESG screens (removing certain securities from their portfolio) or tilts (weighting ESG positive securities more heavily in their portfolio). The investor immediately sees how these tilts and screens affect portfolio characteristics. For example, an investor concerned about climate change and gender equality can screen fossil fuel-related companies and tilt toward companies with gender-diverse leadership. With direct indexing, customization becomes simple, easy, and transparent.

On the plus side, an investor can apply various ESG policy settings as they wish. However, more settings can increase tracking error and introduce deviation from the benchmark. Understanding these tradeoffs is an important job for advisors.

Also, issues in ESG transparency remain prominent. ESG data is a fast-evolving area, with well-documented differences in scores between data vendors, and it can be difficult to arrive at a consensus definition of ESG scores or issues. A best practice is to offer clients a wide range of ESG options that depend on direct ESG measures rather than evaluated scores. Measures like carbon emissions, percentage of women on boards, and revenue from alternative energy are often most tangible and actionable, although it is important to recognize that there will still be debate over which metrics are best. For instance, which specific emissions should be evaluated, and are a company’s actual emissions or its progress in reducing emissions more important? The answers vary from investor to investor, and this is where advisors can add value.

Investors even have a choice when it comes to shareholder advocacy. For funds and ETFs, the fund managers hold discretion over proxy voting. With direct indexing, an investor can choose to vote proxies or delegate to the direct indexing manager. In the latter case, they should feel empowered to provide proxy voting preferences for the manager to implement on their behalf.

Direct indexing for philanthropy

A primary benefit of direct indexing is the ability to harvest losses from individual stocks while still tracking an index. One criticism of direct indexing is that investors have fewer tax-loss harvesting opportunities as the years go by, and the portfolio has an increasing amount of unrealized capital gains. However, for philanthropic investors, direct indexing allows both the harvesting of losses each year and also the opportunity to donate stocks with gains. Donating allows investors to avoiding realizing capital gains, which removes the embedded tax liability of positions with unrealized gains and increases the tax alpha of the portfolio strategy. Donating stocks may be a much more tax-efficient way to rebalance the portfolio and reduce tracking error as well. Furthermore, if the stock donations are in lieu of cash donations, then investors may choose to redirect that cash to the portfolio and immediately repurchase more shares, which will increase the cost basis of the portfolio and create additional opportunities for future tax-loss harvesting.

In today’s quickly evolving investments landscape, direct indexing brings investors and their advisors new options to address specific investment needs, including ESG inclusion and tax-efficient giving. It’s a smart, flexible way of investing. No matter exactly what ESG or philanthropy is to an investor, from a general desire to do good to a specific impact strategy, it can be expressed through direct indexing with choice and transparency.

[This post originally appeared in the June 2022 issue of NAPFA Advisor magazine. Original can be found here:]

A Brief History of Direct Indexing, Custom Indexing, Personalized Indexing, and SMAs

The growth of direct indexing (also referred to as custom indexing, personalized indexing, or an index SMA [separately managed accounts]) is a major development in the investing and wealth management space. Before getting into the details of what it is and how it can be used, I believe it is helpful to review the history of mutual funds and index funds, as well as the major developments that occurred in 2019.

The Invention of Mutual Funds

One hundred years ago, many Americans were investing in the stock market and they relied on brokers to execute their buy and sell orders. The brokers charged commissions, but investors were exposed to other trading costs like the bid-ask spread and unscrupulous market makers (the SEC was not established until 1934). Buying a stock could be an expensive ordeal for individuals, much less buying many stocks to build a diversified portfolio.

In 1924, the first “mutual fund” was launched. Individual investors could now pool their capital in a fund and the fund would buy stocks. Rather than receive shares of stock, investors received shares of the pooled vehicle (they owned the underlying stock mutually, hence the name mutual fund). In a sense, the mutual fund was just a wrapper that held individual stocks. The primary benefit was that investors could purchase a diversified portfolio of stocks with a single purchase.

The Invention of Index Funds

The concept of index investing had been publicly theorized as early as the 1950s. While the mutual fund wrapper was a good vehicle to realize economies of scale for individual investors, some investors were convinced that a lower-cost passively-managed portfolio was superior to a higher-cost actively-managed portfolio. The first index funds were launched in the 1970s and index investing has primarily been delivered to individual investors in a fund wrapper ever since. Rather than buying the individual securities in an index, individuals have overwhelming bought index funds which hold the individual securities in an index. Today, index funds dominate the mutual fund landscape and are nearly synomous with exchange-traded funds (ETFs). The indexing industry’s trade journal and affiliated conference even re-branded from Index Universe to and the Inside Indexing conference is now the Index ETFs conference.

Direct Indexing pre-2019

Some index investors have been investing via separately-managed accounts (SMAs) rather than funds, since at least the early 1990s. However, just a handful of firms offered this “direct indexing” service to investment advisors (and individual investors) and minimum investment requirements were relatively high due to high fixed costs. Although minimum investment requirements had declined over the years, even incurring a fee of just $5/trade (multiplied by hundreds of trades per year) limited direct indexing to larger portfolios. Prior to 2019, there were several “robo-advisors” that rolled out direct indexing offerings, but those offerings left a lot to be desired. However, there have been a handful of recent developments and new entrants that have made direct indexing a much more attractive and feasible option for many investors.

What Changed in 2019

In February 2019, the 2019 Inside ETFs conference began with a keynote on “The State of the ETF Union.” Rather than focus on ETFs, the joint keynote speakers (Matt Hougan of Insides ETFs and Dave Nadig of focused on what was coming next. Hougan and Nadig predicted that there would be a “great unwrapping” as investors shifted from index fund investing to direct investing. The presentation centered on JustInvest’s direct indexing solution (Just Invest was acquired by Vanguard in 2021), although it mentioned that Parametric (owned by Eaton Vance at the time, which was acquired by Morgan Stanley in 2021) and Aperio (later acquired by BlackRock in 2020) has large direct index offerings. For the top names in the index fund world to say this was surprisingly to say the least, but their timing could not have been more prescient (as evidenced by all the acquisitions in 2020 and 2021)!

Charles Schwab cut their trading commissions to $0 on October 1, 2019.  TD Ameritrade followed suit that afternoon, E-Trade the next day, Fidelity the next week, and Vanguard the following quarter. After a decades-long price war that saw trading fees reduced a dollar or two at a time, every major broker went to zero in an instant. The elimination of trading fees was a long-awaited and welcome development for all investors. It also meant that much smaller accounts could utilize direct indexing and the wave of custodians introducing fractional share trading should reduce the minimum account size even further. 

Looking Ahead

I have a lot of jokes about forecasts and predictions, so I will not offer any here. However, I have observed changes that I expect will continue:

  • Direct indexing will be the best choice for many taxable accounts, especially for investors with the highest tax rates. Mutual funds and ETFs will remain appropriate in many situations, but direct indexing will increasingly be the right choice.
  • There will be an increase in the number of direct indexing providers and services. I have used several direct indexing solutions and can say that investors need to clearly understand the benefits and drawbacks of each offering. I have seen some great direct indexing offerings, as well as some terrible ones.
  • A direct indexing offering will be table stakes for every investment advisor. Advisors have increasingly adopted and recommended direct indexing as trading costs have declined over the years, but there is no excuse to not have a direct indexing option today.
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