Key Points:
- Direct indexing is gaining popularity in the asset management industry, with major firms like Morgan Stanley, BlackRock, JPMorgan, Vanguard, and Franklin Templeton acquiring direct indexing subsidiaries or platforms.
- Direct indexing allows for fully customized portfolios, tailored to the client’s preferences and with the option for tax-loss harvesting.
- However, the customization and active management involved in direct indexing may not lead to better performance than traditional mutual funds or ETFs.
- Tax-loss harvesting, while a beneficial feature, carries risks and may not always result in reduced tax liabilities.
- Investing based on personal preference in direct indexing may lead investors to miss out on the top-performing stocks and take on unnecessary risks.
- For most investors, a passive approach through ETFs may be a more effective and low-cost solution.
Introduction
The asset management industry has shown increasing interest in direct indexing, with major players like Morgan Stanley, BlackRock, JPMorgan, Vanguard, and Franklin Templeton acquiring direct indexing subsidiaries or platforms. Direct indexing allows for fully customized portfolios tailored to the client’s preferences, with the added benefit of tax-loss harvesting. However, is direct indexing really as advantageous as it seems?
An Overview of Direct Indexing
Direct indexing has seen significant growth in assets under management (AUM) since 2015, primarily driven by the availability of cheaper and more user-friendly software for creating customized portfolios. Millennials, in particular, have shown interest in personalized portfolios with a focus on environmental, social, and governance (ESG) considerations.
The Dark Side of Direct Indexing
While direct indexing offers fully customized portfolios, it essentially involves active management. Clients who eliminate or underweight certain stocks based on personal preference are essentially doing what active US large-cap fund managers do. However, most professional money managers consistently underperform their benchmarks, making it unlikely that individual investors will outperform them.
The Risks of Tax-Loss Harvesting
One of the key benefits of direct indexing is tax-loss harvesting, where stocks with losses are sold to offset capital gains. However, managing a portfolio based solely on tax decisions can be risky, as it may involve selling losers at the wrong time and missing out on their potential recovery. Additionally, tax-loss harvesting is still a form of active management and may not always result in reduced tax liabilities.
Further Thoughts
While direct indexing offers the allure of customization and personalization, it may not necessarily lead to better performance compared to traditional mutual funds or ETFs. Many investors have turned to passive investing through ETFs, as it provides an effective solution for most investors who are unable to consistently outperform benchmark indices. Fully customized portfolios have historically been reserved for high-net-worth clients and may not be suitable for every investor.
Note: This article was originally published on Investopedia.
