A look at common objections to direct indexing

We’ve written before about the advantages of direct indexes over ETFs and Index Funds (see Why all the Direct Index Acquisitions and How to Implement Direct Indexes). And we’re not alone. The coming rise of direct indexes has even been called “The Great Unwrapping.”¹ But not all are convinced, so we thought we’d address some common objections to direct indexes.

Objection 1: Direct indexes are unwieldy. (Who wants to own 500 shares?)

Response: Owning the 500 securities in the S&P 500 — or, worse, the roughly 5,000 securities in the FTSE Russell 5000 — would seem to make for dreary statements and endless Schedule D’s. But with computer-generated statements and tax statements, this seems to be a declining problem. More importantly, direct indexes rarely include all the holdings in the underlying index. Most direct indexes held by individual investors are just a representative sample of the index holdings, say 50 to 150 stocks. It’s less fuss and less expensive.

Objection 2: Direct indexes do a poor job of tracking indexes.

Response: As mentioned above, most direct indexes don’t hold all the securities in an index; they hold a representative subset, which, indeed, won’t track indexes perfectly. However, for most non-institutional investors, this doesn’t matter since the purpose of investing is not to track an index; it’s to maximize after-tax, risk-adjusted returns. And this is where direct indexes shine. Due to their tax efficiency, direct indexes outperform comparable ETFs and index funds on an expected after-tax basis. ² They’re also customizable — you can add social screens, work around outside holdings, counterbalance geographic and employment risk exposures, etc.

Objection 3: High minimum investments put direct indexes out of reach of ordinary investors.

Response: At present, there’s still some truth to this, but this is changing fast. Absent fractional shares ³, the practical minimum for owning a direct index is around $100,000. Anything less, and it becomes difficult to own shares in the index in the right proportion. Think about Google, which trades at around $2,600 / share. If you invested $10,000 in an index, one share would be 26% of your portfolio, which is likely way more than you want. But fractional shares are becoming more common. Just last week, Fidelity announced that it would offer direct indexes with fractional shares to retail clients with a minimum $5,000 investment, and other custodians, including Schwab, Apex Clearing, Interactive Brokers and DriveWealth all currently support fractional shares. Together with the $0 commissions recently offered by all the major custodians, fractional shares have the potential to make direct indexes accessible to investors with as little as $100.

Objection 4: Direct indexes are expensive, which negates any advantage they have over ETFs.

Response: Historically, direct indexes have been premium products, costing far more than similar ETFs, and this did negate much of the direct index’s tax advantage. But technological advances have made it possible to deliver direct indexes at radically lower prices. The management of direct indexes, even with tax optimization and high levels of customization, can be largely automated. So, at scale, direct indexes should be less expensive than both index funds and ETFs, which are structured as investment companies that are required to register with the SEC, have governing boards, and file annual reports. Direct indexes have none of this overhead. 

So what is stopping investors from adopting direct indexes? Mainly, familiarity and availability. Fractional shares, convenient access and low prices are coming, but they’re not universally available yet. It took index funds years to come into their own, and it will likely take time for direct indexes to do the same. But the benefits to investors make the long-run success of direct indexes seem pretty much inevitable. Let the great unwrapping begin.

SAM and direct indexes

SAM offers both direct index separately managed accounts (SMAs) and unified managed accounts (UMAs) with direct index cores. With UMAs, the client wealth advisory firm retains control of asset allocation and product choice, including the option to subscribe to third-party asset allocation models. (SAM recently announced that it includes in its base offering asset allocations and direct index portfolios tied to Morningstar indexes.)

¹We like the phrase “The Great Unwrapping” and wish we had come up with it, but credit goes to Inside ETFs’ Chairman Matt Hougan and ETF.com CEO David Nadigand, dating back at least to 2019. See What’s Next in ETFs? The Great Unwrapping

²Outperformance is expected but not guaranteed. One of the advantages of direct indexes is that they give the owner more options for loss harvesting, and, on average, this is good for investors. However, it is not guaranteed to work every time; for example, the security you sell at a loss could rebound soon after you sell it and the replacement security you buy in its place could drop in value. 

^{3 Fractional shares mean investors can buy or sell less than one whole share, typically any increment of 1/1000 of a share.}