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Direct Indexing vs ETFs: What advisors need to know

For years, exchange-traded funds (ETF) were seen as the likely heir to mutual funds’ throne. Mutual funds are expensive, inefficient, and opaque. Everything that ETFs are not. So it makes sense that active mutual funds experienced nearly $200 billion in outflows over the past decade when passive funds took in $3.8 trillion. 

But as this shift has unfolded, a new challenger has emerged that may unseat both ETFs and mutual funds. The emergence of direct indexing now gives advisors more options to create personalized portfolios. Before it can become the industry standard, advisors must understand the similarities and differences between what they use, ETFs, and what they may not yet, direct indexing.  

What are direct indexing and ETFs?

At a glance, direct indexing and ETFs aren’t all that different. Both approaches try to replicate the performance of an index by holding a basket of stocks. In doing so, advisors can give clients a diversified portfolio for reaching their goals. 

The difference is in how they make this happen. ETFs were designed to give everyday investors access to the market more efficiently than was previously possible. Each fund, typically created by an asset manager, holds a representative basket of stocks or bonds that reflect its benchmark. It, by design, means those who hold ETFs have indirect exposure to the assets in the fund. 

By comparison, direct indexing gives investors direct exposure to the securities in an index. Advisors purchase the underlying individual securities of an index rather than the ETFs or mutual funds that track them. So, for example, investors can hold all 500 stocks or a representative share of the S&P 500 instead of purchasing the SPDR S&P 500 ETF (SPY). This gives advisors more flexibility to mix and match assets in a way that reflects their clients’ goals and preferences.

Direct indexing and ETFs: similarities and differences

Customization: Investors deserve a more personalized experience than what ETFs can deliver. With direct indexing, advisors can provide greater personalization around clients’ values and ESG preferences. They do this by removing stock and sectors that their client’s may find objectionable. What’s more, investors may have large concentrated positions from an employer-granted option. It’s easy to remove those names or other stocks that behave similarly. Advisors will need to remember that direct indexing is, in many ways, index investing. Make too many changes, and a client’s portfolio will look a lot different than the index in focus. 

Tax Efficiency: No one likes paying more taxes than they have to. It’s this ability to lower investors’ tax liabilities that make direct indexing so appealing. By holding individual securities, advisors can harvest losses at the stock-level and set capital gains budgets, so clients can better control tax liabilities. ETFs are also capable of tax-loss harvesting but only at the portfolio-level, meaning to harvest losses, investors must sell the ETF position entirely to another ETF instead of the individual losing positions. 

>> Read more about how an advisor is using technology to gain an edge in his practice.

Average Fees: The steady decline in fees has made ETFs an attractive option over the past few decades. It’s still the case today. ETFs are the cheapest option for building a diversified portfolio. Cheaper than mutual funds. Cheaper than direct indexing. Cheaper than custom indexing. If costs are the primary concern for clients, ETFs may prove to be the most viable solution. 

Investment Minimums: Accessibility can be a sticking point for advisors and their clients considering direct indexing. When advisors use direct indexing platforms, they do so through separately managed accounts. A separately managed account typically requires a minimum investment of $100k or more. That exceeds how much investors need to get started with ETFs. 

A lot of progress has been made to give investors portfolios that reflect their goals and values. Direct indexing is just the latest in that lineage. But before advisors abandon ETFs and mutual funds, they should find the right place to incorporate direct indexing in their clients’ portfolios.

July 13, 2022