Foundations & Endowments

What is an Index Fund and is it Reasonable to Invest in? The Benefits of Direct Indexing Explained

Savvy

March 11, 2024

#Savvy

An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to track the performance of a specific market index, like the S&P 500 or the Dow Jones Industrial Average¹. Index funds invest in the same stocks or bonds at the same weights as the index they track². This makes them a more diversified and low-cost way to invest compared to picking individual stocks.

Index funds have become extremely popular over the past few decades. As of 2023, index funds account for over 50% of total fund assets, up from less than 20% in 2000³. This shift has occurred because research generally shows that index funds perform better than actively managed funds over the long run¹. Actively managed funds try to beat the market by frequently trading stocks, but most fail to match net returns of index funds over time, after fees and expenses.

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Benefits of Index Funds

There are several key benefits that make index funds an attractive investment⁴:

Diversification: Index funds provide instant diversification across hundreds or thousands of stocks and bonds. This reduces portfolio risk compared to owning just a few stocks.
Low Cost: Index funds do not require extensive research and trading of securities like actively managed funds, so they have lower expense ratios. These small differences in fees compound over decades and lead to tens or hundreds of thousands of dollars in extra portfolio growth.
Tax Efficiency: Index funds trade infrequently, so they generate lower capital gains distributions compared to actively managed funds. This saves investors money on taxes every year.
Transparency: Index funds clearly publish their exact portfolio holdings daily, so investors know exactly what they own. Actively managed mutual funds only disclose their top 10 holdings quarterly.

So in summary, index funds provide a low-cost, diversified, and tax-efficient way to invest that has outperformed most active managers over time. This makes them a relatively safe choice for long-term investors compared to picking individual stocks.

Introduction to Direct Indexing

Direct indexing is a newer innovation that provides all the traditional benefits of index funds while allowing for greater customization and tax optimization ⁶.

With direct indexing, an investor owns the underlying stocks of an index directly rather than owning shares of an index mutual fund or ETF. For example, to track the S&P 500 an investor would work with a firm to build a portfolio of the 500 companies in the index.

This structure provides investors with more control, including the ability to⁷:

Customize their portfolios by excluding certain sectors or stocks
Further optimize the investments from a tax perspective through loss harvesting
Incorporate environmental, social, and governance (ESG) factors into stock selection

Direct indexing portfolios are now also accessible to investors without millions of dollars thanks to fractional share trading and automated software to manage the accounts. The minimum investment is often between $25,000 to $100,000.

So in summary, direct indexing provides all the traditional benefits of index funds while allowing investors more control over customization, tax optimization, and ESG factors.

Direct Indexing Benefits for High Net Worth Investors

While direct indexing can benefit all types of investors, it is especially useful for high net worth individuals and families for several reasons⁸^:

1. Greater Tax Optimization

Wealthy investors generally have higher income tax rates and more taxable investment accounts. Direct indexing provides more opportunities to harvest investment losses to offset realized capital gains. This tax alpha can boost after-tax returns by around 1-2% annually9.

2. Ability to Exclude Certain Stocks

High net worth investors may want to avoid investing in certain companies for ethical, political, or other personal reasons. With direct indexing, investors can customize and exclude stocks from portfolios rather than being forced to own everything in a broad index fund.

3. Transition Concentrated Stock Positions

Affluent investors sometimes have concentrated public or private company stock positions they want to diversify away from. Direct indexing provides a tax-efficient way to slowly sell down positions while offsetting gains with loss harvesting.

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4. Incorporate ESG Factors

Many wealthy investors care about incorporating environmental, social, and governance (ESG) factors into their investments. Direct indexing allows granular customization to tilt portfolios towards companies with leading ESG practices.

5. Access Unique Investment Strategies

Direct indexing also allows the incorporation of more complex rules-based investment strategies focused on factors like momentum, volatility, quality, or dividends. This customization is not possible with traditional index funds and ETFs.

So in summary, direct indexing provides substantial advantages to high net worth investors who want greater control over customization, tax optimization, ESG factors, and specialized investment strategies.

Is Direct Indexing More Expensive?

Direct indexing does come with additional costs compared to basic index funds and ETFs since separate accounts must be set up for each investor and fractional shares purchased¹⁰. However, for larger portfolios, the incremental fees are generally quite small, especially given the tax savings and customization benefits.

Most direct indexing portfolios have an annual asset-based fee around 0.20% to 0.50% depending on the provider and services included¹¹. So a $1 million portfolio would pay between $2,000 to $5,000 annually. Basic index ETFs often have expense ratios under 0.10%, so the incremental fee for direct indexing averages 0.15% to 0.35% higher for wealthy investors.

However, multiple studies show the additional tax alpha from loss harvesting generally far outweighs the incremental fees. For example, a 2022 study published in the Journal of Financial Planning showed leading direct indexing providers captured over 2% in tax alpha for taxable accounts over a 7-year period¹². So the net benefit even after higher fees was around 1.5% to 1.8% annually.

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Conclusion

In conclusion, index funds provide diversification, low costs, transparency, and tax efficiency that can help investors across the wealth spectrum grow their nest egg over the long run. The S&P 500 and total stock market index funds are safe choices for long-term retirement savers.

Direct indexing takes the benefits of traditional index funds further by allowing complete customization over portfolio holdings. It also provides high net worth investors with enhanced tax optimization and the ability to align investments with their values. While direct indexing costs more than basic index funds, the tax savings generally outweigh the fees for larger portfolios.

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