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March update: news, opinion and comment for your financial wellbeing 

Go it alone or managed funds?
Weighing up the options for indexing.

Part two of our look at direct investing

In last month’s newsletter, we introduced the concept of direct indexing. Now, we’re outlining the potential drawbacks, and why we believe our approach of using funds rather than investing directly in individual stocks is a more effective way to pursue your long-term financial goals.

What’s your endgame?

Let’s start by taking a step back. Why invest to begin with? We believe it’s to create or preserve enough wealth to fund your future goals, even as inflation nibbles away at our money’s spending power over time. An additional, immediate reward comes from the tranquility you feel today, knowing you have a dependable financial safety net to protect yourself against tomorrow’s unknowns.

The key point is this: you and your ideal investments must not only start out strong, they must have the stamina to last.

Direct indexing is unlikely to be the best way to achieve this. The complexities involved will probably make it harder to build, manage and stick with the ideal low-cost, globally diversified investment portfolio that's tailored to reflect your personal financial goals and risk tolerances.

Here’s why.

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 regularly 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.
  • Rebalancing: markets move too. To sustain your investment allocations, you’ll periodically buy more of the recently underperforming assets and sell some of the latest winners.         
  • Reallocating: your own financial goals may also evolve over time, calling for a shift in your underlying allocations. This means additional trading to stay on track with your goals.

Tax entanglements

With traditional index investing, if you harvest tax losses or incur taxable gains to rebalance 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 could find yourself placing hundreds of trades, several times a year. Each trade becomes a line item that you and your accountant must accurately track and report on your tax return.

Active temptations

What if you’re using direct indexing to make individual exceptions to a standard index fund or similar asset-class approach? There are understandable reasons for doing this, especially if you want to focus on sustainable/ethical companies, for example, but it does generate extra complexity, and make it harder to stay on course and achieve your overall financial goals. Questions to ask yourself:
  • If you’re no longer closely tracking indexes or similar standardised 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 underperforms 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. A fund manager can add value in other ways, too:  
  • 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.
  • They can find global core funds that replicate a typical asset-allocated portfolio for you — including rebalancing when necessary.
  • Some fund managers offer tax-managed versions of their funds.
  • If you want to integrate sustainable, ESG (Environmental, Social, and Governance), or other values-based investing into your structured portfolio, there are a growing number of funds that will do this for you.

Simple, sensible success

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. And it should be simple enough to stick with long term. 

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 impact of Ukraine

The invasion of Ukraine by Russia is such a devastating humanitarian, political and economic event that it's hard to believe it won't have an equally devastating impact on the markets and, therefore, on your portfolio.

And, obviously, the immediate impact has been significant - especially if you hold a lot of commodities or are exposed to Russian assets.

At times like this (and there have been times like this before, of course), we need to tune out of the market chatter. Fortunes will be made and then lost by speculators, but evidence based investors like us should hold firm. The illustrations below, showing the Bull and Bear markets of the UK (left) and US (right) over the last 100 years, demonstrate how quickly they recover.

So hold firm, and focus your energies on practical measures to help the Ukrainian people - such as donating to the Disasters Emergency Committee Ukraine Appeal.

If you'd like to talk to us about this, please don't hesitate to give Kevin a call. 

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