A Q&A on direct indexing
We've compiled a list of frequently asked questions about direct indexes in our Direct Indexing FAQ. Below is an excerpt.
What are direct indexes?
Direct indexes are baskets of securities (e.g. IBM, Ford) that 1) track the performance of an index and 2) are directly (hence the name) owned by investors. Direct indexes stand in contrast to index funds, which also track an index, but don’t provide investors with direct ownership of the underlying securities — instead, the investor owns shares in the fund, which, in turn, directly owns underlying shares.
Do direct indexes track their target indexes as well as index funds?
They can, but direct indexes are usually managed in a way that will cause their returns to depart from those of the underlying index. Sources of return deviation include:
If direct indexes don’t track the underlying index exactly, are they really “index” portfolios ?
Most direct indexes really do aim to track, not outperform, their underlying index. And none are traditional “pick winning stocks one-at-a time” actively managed portfolios. On the other hand, they are usually significantly worse than comparable index funds in terms of their tracking error (drift) to the index.
So, there’s good reason to call them indexes and also good reasons to quibble. But, at the end of the day, the name doesn’t really matter. They’re customized, tax-optimized portfolios of individual securities constructed with an index benchmark as a starting point.
Why are direct indexes getting lots of attention now?
It’s a combination of an increase in both supply and demand.
On the demand side, we see greater interest by advisors and investors in tax management, risk customization and impact investing – areas where direct indexing shines.
On the supply side, there have been multiple technological advances that make direct indexes more affordable and accessible. There’s a back-to-the-future quality to direct indexes. Owning baskets of stocks long predates the invention of the mutual fund or the ETF. Direct indexes themselves have existed for decades. What’s new is that while direct indexes used to make sense only for ultra wealthy investors, they're now affordable and practical for ordinary investors; they can now be offered at a price point that makes them a superior alternative to ETFs for most investors. The technological innovations that have made this possible include:
See the complete Direct Indexing FAQ