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:]

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