Fixed and active strategy funds can offer investors set-it-and-forget-it options for their portfolios. However, some may want a higher degree of customizability. With direct indexing, investors can essentially become their own portfolio managers.
“When you own the stocks directly, you are ultimately the portfolio manager,” Karen Wallace wrote in Morningstar. “That means you can customize the index if you want to. Are there securities in the index that don’t align with your values, from an environmental, social, and governance perspective perhaps? Direct indexing allows you to sell or avoid them.”
However, the drawback is the potential of not mirroring the index one-to-one. Holdings are essentially in the hands of investors. Therefore, the chances are high that various portfolios tracking an index will vary from one person to the next.
“One thing to be aware of: If your version of the index starts to look a lot different from the ‘real’ index in terms of sector weightings and so on, the performance won’t match up, either,” Wallace warned. “This is called tracking error.”
Direct Indexing Offers Customizability
All in all, the ultimate benefit to investors is customizability. Tracking error is a risk. However, the portfolio could be more in line with an investor’s own goals, like tax-loss harvesting or ESG goals.
“What direct indexing does is it tailors an index to meet an investor’s specific circumstances, and optimizes for things like taxes, or ESG exposure, or factor exposure,” said Ben Johnson, head of client solutions for Morningstar.
Johnson continued: “Where that lands an investor is a place that looks very different from starting point, which was a broad-based, market-cap-weighted index. But it’s been cut to fit their preferences, so it’s ultimately going to take the shape of a separately managed account. How they get from that starting point to that tailored portfolio is increasingly some sort of software application that brings to bear all of the data around taxes, tax preferences, and tax lots; ESG criteria; factor exposures; you name it.”
One way to experience direct indexing is via the Vanguard Personalized Indexing. It offers a wide range of screens and tilts for investors to attain that level of customizability while offering performance reports to measure the impact of their investment decisions.
For more news, information, and analysis, visit the Direct Indexing Channel.
