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

Direct indexing - is it for you?

As if we didn’t already have enough investment strategies to choose from, a (sort of) new one has been receiving extra attention lately: direct indexing.

By the middle of the decade, according to the FT, direct indexing is forecast to rise from its current $500 billion of global assets to $1.5 trillion, mainly at the expense of other passive products such as mutual funds and ETFs. 

Over the next couple of months, we’ll take a look at this ‘new’ approach to index investing and review some of the pros and cons. 

So what is direct indexing?

In a nutshell, it’s a bespoke approach to off-the-shelf index funds. These buy a share of every company in an index and pool the holdings in a fund in which you invest, and which tracks the performance of the market. 

A direct indexer buys individual stocks that mimic an established index. The difference? You then customise your portfolio to manage tax losses or boost those companies with a strong ESG (environmental, social and governance) profile, for example.

How does it work? 

Let’s say you have £100,000 you’d like to allocate to the asset class of US large-company stocks, as proxied by the S&P 500. Here’s how you or your investment manager might proceed:

Set up: 
As an index fund investor, you buy £100,000 worth of an S&P 500 index fund, weighted by market capitalisation. You would then indirectly hold all US large-company stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index. 

As a direct indexing investor, you could achieve the same exposure to the same collection of US large-cap growth stocks by investing £100,000 directly in the individual stocks tracked by the S&P 500, in similar allocations to each stock’s weight in the index. 

As an index fund investor, your account statements would show a single position in one fund representing a US large-cap stock allocation (as proxied by the S&P 500). To hold a larger or smaller allocation to this asset class, you would buy or sell shares of this single fund.

As a direct indexing investor, they would show hundreds of different stock positions (or at least enough stocks to accurately emulate the index). You could then individually buy or sell shares from each position to alter your US large-cap stock allocation.

As an index fund investor, the fund would alter its underlying holdings when the S&P 500’s holdings or weights changed in the index. So you continue to track the index without having to change anything.

As a direct indexing investor in a similar scenario, you would need to place trades across your individual positions to continue tracking the index.

When selling fund shares as an investor in an index fund, you’d realise a gain or loss based on how much you paid for each mutual fund or ETF share.

As a direct index indexing investor, you’d realise a gain or loss based on how much you paid for each stock share. 

Why do it?

Direct - or personalised - investing has long been available at a cost to wealthy investors. But technology is making it more practical for individual investors. 

Many trading platforms have cut trading fees, making it more cost-effective to buy and sell a lot of individual securities. They have also allowed fractional share purchases, so you can capture an index’s holdings in smaller slices. 

As a result, more providers are offering direct indexing services to smaller accounts for relatively modest fees. So you could start with a popular index, and add exceptions based on your personal financial goals or to include a values-based filter (increasing your holding in ‘virtuous’ stocks at the expense of ‘sin’ stocks, for example). Or, if you’re employed in a hot sector such as technology, you might reduce some of your exposure to that sector, to offset the concentrated risks you’re already incurring through your career. 

From a tax point of view, if you invest in index mutual funds or ETFs, you can only incur gains/losses on the fund’s share price. With direct indexing, you can trade on each underlying security you hold. So for your taxable accounts, direct indexing offers more flexibility to manage when and how to incur taxable gains and losses, with an eye toward reducing your lifetime tax liabilities.

The downside is that the more you use the strategy, the more difficult it gets to harvest losses - because, eventually, you will have sold all of the losing stocks in your portfolio.

Is it worth It? Watch this space.

What are the trade-offs when you choose to move from index funds to direct indexing? We’ll cover this in next month’s newsletter, and let you know why direct indexing may not be the best choice for you. 

If you can’t wait that long, just get in touch and we’ll be happy to talk you through the pros and cons and how they relate to your investments. 

Why a stock peak isn't a cliff

You could be forgiven for thinking a market high is a signal that shares are overvalued or have reached a ceiling. But you may be surprised: data from our friends at Dimensional shows that record returns don't necessarily show through one, three or five years on. Download this short explainer to find out more. 

Transact fees reducing

Great news for our clients whose fees are invested via the Transact platform (yes, that's you, <<First Name>>.) 

Transact is reducing its fees again which means the cost of investing is dropping, too. We'll let you know what this means for you when we have our next annual planning meeting. 

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