A direct indexing portfolio is a separately managed account based on a chosen market-cap-weighted benchmark whereby investors can personalize their accounts to incorporate desired factors; tilts; and environmental, social, and governance (ESG) preferences, or to account for concentrated positions. Unlike a mutual fund or an ETF, the investor owns the securities directly in the SMA.
Assets under management in direct or personalized indexing portfolios have more than tripled between 2015 and 2021, and research estimates that AUM in these kinds of accounts could reach $1.5 billion by 2025. Clearly, interest in direct indexing is growing.
But of course, this increased interest comes with increased questions, ranging from what the differences between similar direct indexing implementations are to how much personalization investors can incorporate without potentially jeopardizing expected returns. With financial advisors and investors alike having more questions about this type of investing, Vanguard issued a white paper offering guidance on constructing a direct indexing portfolio that best suits an investor’s needs.
One main reason to use a direct indexing strategy is its tax-loss harvesting capabilities. Direct indexing software scans the portfolio for harvesting opportunities at a set frequency (daily, quarterly, or monthly). Per the investment giant, the frequency at which a personalized indexing strategy scans for tax-loss harvesting opportunities is crucial.
Generally, the more frequent the scans, the higher and more consistent tax-loss harvesting. The differences in alpha can range from 20 basis points to more than 100 bps. When considering a direct indexing strategy for its tax-loss harvesting abilities, those with daily harvesting scans “is critical to achieving the maximum harvest in ‘typical’ (non-high) volatility environments,” according to Vanguard.
There’s also the question of tracking errors and how much the investor can tolerate. A typical direct indexing portfolio has a tracking error between 75 and 275 bps (with 75 bps representing the minimum level of tracking error that can result from tax-loss-harvesting using individual securities and navigating the wash-sale rule). The higher the customization, the higher the probable tracking error.
How much personalization an investor can pursue without sacrificing performance will vary dramatically depending on the investor and their needs. Investors with an expected direct indexing alpha of 150 bps or more can largely replace their existing passive U.S. equity allocation with direct indexing and freely customize without having to change their overall allocation. Those with an expected direct indexing alpha below 150 bps, on the other hand, may find that personalization can come at a cost.
High-net-worth investors looking to benefit from the tax optimization and customization features of direct indexing may want to consider Vanguard Personalized Indexing. VPI’s algorithms automatically review each account daily and harvest individual security losses as opportunities arise.
For more news, information, and analysis, visit the Direct Indexing Channel.