Our Take on Direct Indexing Part 2: Is It Worth It?

Lately, there’s been a fair amount of buzz about direct indexing as an investment strategy.  In our last piece, we introduced direct indexing: how it works, why it’s been receiving more media attention, and what potential tax and investment management advantages it might offer over traditional index investing.  Today, let’s talk about why we’re not as enthused by direct indexing as we are by our funds-based approach to helping you pursue your long-term financial goals.

What Is Your End Game?

Let’s start by taking a step back.  Why invest to begin with?

We believe the best reason to invest is to create or preserve enough wealth to fund your future goals, even as inflation nibbles away at our money’s spending power over time.  But we also believe there’s another important reason – the certainty of uncertainty.  When it comes to life events and their financial implications, there are countless uncertainties.  There is just so much we can’t predict. Embracing that truth – the very certainty that life is going to be uncertain – motivates us.  It empowers us to take action – to invest - and pursue, to the degree possible, financial security and independence for ourselves and our families.   

This leads to a critical understanding: You and your investment and financial plans must not only start out strong, they must have the stamina to last.

We’re not yet convinced direct indexing is the best strategy for this essential duty.  The complexities involved may make it harder rather than easier to build, manage, and stick with your diversified investment portfolio, tailored to reflect your personal financial goals and risk tolerances.

Course Corrections

Effectively tracking an index over time isn’t as simple as it may sound.  Like trying to walk across a swaying bridge on a spinning planet, everything is in constant motion.  Managing all the movement (and reporting it on your tax returns) can leave you dizzy.

·       Reconstituting: The index you’re tracking periodically reconstitutes its holdings, removing companies that no longer best represent its target asset class, and adding ones that do.  To continue tracking the index, you’ll need to shift your holdings as well.

·       Re-balancing: Markets move too.  To sustain your investment allocations, you’ll periodically buy more of the recently under-performing assets and sell some of the recent winners.    

·       Reallocating: Your own financial goals may also evolve over time, calling for a shift in your underlying allocations.  This too requires additional trades, to stay on track with your goals.

Tax Entanglements

With traditional index investing, if you (or your advisor) harvest tax losses or incur taxable gains to re-balance or otherwise manage your portfolio, you’ll trade a few funds, and report the results on your annual return.  To accomplish these same tasks with direct indexing, you or your service provider might need to place hundreds of trades, several times a year.  Each trade becomes a line item you and your accountant must accurately track and report come tax time.

Active Temptations

What if you’re using direct indexing to make individual exceptions to a standard index fund or similar asset-class approach?  This generates additional layers of complexity, which can make it harder to stay on course toward your desired destination.

·       If you’re no longer closely tracking indexes or similar standardized benchmarks, at what point do you lose control over understanding your portfolio-wide risks and expected returns?

·       How do you make sensible adjustments over time, without throwing your portfolio’s carefully structured asset allocations out of whack?

·       Will you succumb to tracking error regret, and lose your stamina if your portfolio under-performs its closest benchmark (even if it’s expected to)?

·       Why are you making the exceptions to begin with?  If it’s to bring your total portfolio closer to its intended asset allocation, it might make sense.  If you believe you know more than the market does about what lies ahead, you’re no longer investing; you’re speculating.

Operating Efficiencies

By building your portfolio using well-managed, low-cost index or similar asset-class funds, you’re essentially hiring a professional to manage many of these complexities for you.  The complexities don’t necessarily go away, but most of them happen behind the scenes.  Especially over time, this offers a cleaner view of where you’re at and where you’re headed, which can in turn make it easier to maintain your investment stamina.

A quality fund manager can also often add value to your experience. For example:

·       A fund manager’s economies of scale may offer them more leverage than you have as an individual investor.  This can help them trade more patiently and cost-effectively when an index undergoes reconstitution, or market prices are swinging to extremes.

·       You can find global core funds that replicate a typical asset-allocation portfolio for you—including taking care of re-balancing it over time.

·       Some fund managers offer tax-managed versions of their funds.

·       These days, there are a growing number of strategies for those who would like to integrate sustainable, ESG (Environmental, Social, and Governance), or other values-based investing into their structured portfolios.

Simple, Sensible Success

Part of investment success comes from investing according to a plan that makes sense to you.  It also should make sense for you, given your goals.  It should increase your ability to build the wealth you need, while managing the risks involved.  As important, it should be simple enough to stick with—basically forever.

At least on paper, direct indexing offers some of these qualities.  But why try to dismember an efficient machine into its individual parts?  For the vast majority of investors, we can deploy a simpler, cost-effective, funds-based approach to closely track your personal financial goals.  As “Fortunes and Frictions” investment blogger Rubin Miller said in an investment lessons post:

 “Successful investors architect successful outcomes.  An often under-respected element of elite investing is that more effort typically leads to worse outcomes.  If you want to be an elite doctor or lawyer – wake up early, study hard, try to attend great schools.  But if you want to be an elite equity investor, simply buy the global stock market for a low cost, and get the hell out of the way. The logic is simple, but implementation is grueling.”

 Please be in touch if you’d like to learn more about our approach to portfolio management.

 It Would Be Our Privilege To Help.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Re-balancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.  Investing involves risk including loss of principal.

Stock investing includes risks, including fluctuating prices and loss of principal.  No strategy assures success or protects against loss.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.  Asset allocation does not ensure a profit or protect against loss.

Socially Responsible Investing (SRI) / Environmental Social Governance (ESG) investing has certain risks based on the fact that the criteria excludes securities of certain issuers for non-financial reasons and, therefore, investors may forgo some market opportunities and the universe of investments available will be smaller.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.

Investors should consider the investment objectives, risk, charges and expenses of the mutual fund, variable annuity contract and the variable annuity sub-accounts carefully before investing. The prospectuses and, if available, the summary prospectuses contain this and other important information about the mutual fund, variable annuity contract and variable annuity sub-accounts. You can obtain prospectuses and summary prospectuses from your financial representative. Read carefully before investing.

This information is not intended to be a substitute for individualized tax advice.  Please consult your tax advisor regarding your specific situation