By Eric Reich
A hot topic in the world of investing lately is direct indexing. Direct indexing is when instead of buying an index fund or ETF, you purchase the actual underlying stocks that make up the index itself. There are a variety of reasons why an investor might want to build a portfolio this way. This week let’s explore how it works and what the potential benefits of direct investments could be.
1. Tax efficiency is certainly a potential benefit of direct investing. If you hold the underlying stocks directly, you can choose both the amount and timing of any capital gains distributions. You could also manage those potential gains by realizing potential offsetting losses which could minimize you taxes in a given year.
2. Reducing risk could also be a potential benefit of direct indexing. Sometimes there is a particular sector that is performing poorly over a given time period. Direct indexing allows you to avoid or sell out of that sector within the portfolio which you couldn’t otherwise do with a mutual fund or ETF. You could also skew the portfolio to those stocks within the index that have a lower-than-average Beta which is defined as the volatility of a stock relative to the market. 1 is the market’s beta, so any number lower than 1 would imply less risk than the broader market. Note, this does not mean that it will necessarily perform better.
3. Environmental, social, and governance or ESG investing*. ESG investing has become another huge topic in the investment world and concerns investing in companies whose focus is on socially responsible investing. While there is a great debate over the pros and cons of ESG investing, direct indexing makes it much easier for you to include or exclude companies whose values do or don’t align with your own.
So, who is direct indexing a fit for. For starters, creating your own index can be very expensive to replicate due to the cost of each stock in the index. It is far cheaper to buy a fund or EFT than it is to recreate it yourself. This is why it is typically done by investors with larger non-IRA portfolios. So, the first negative to me would be,
1. Costs to recreate the index. It is potentially very expensive to recreate an index with individual stocks.
2. Management of the portfolio. The benefit of direct indexing is that you get to pick and choose the stocks in the portfolio. This, however, is not a benefit to everyone. Knowing what stocks to buy, hold, and sell along with when to do make those trades is most often best left to professionals unless you are willing to do an awful lot of research on many different companies and continuously monitor them all on an ongoing basis as well.
While clearly not for everyone, direct indexing might be a consideration with many potential benefits for larger investors seeking to potentially reduce taxes and have more control over their portfolios.
*Be aware that there are not yet universally recognized standards for ethical investing and the categories of investing contained under that umbrella. If you are committed to using your money in a way that reflects your values, it is incumbent on you to do your homework and make sure the companies you’re investing in stand up to what it claims to be. Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. To view form CRS visit https://bit.ly/KF-Disclosures.
Eric is President and founder of Reich Asset Management, LLC. He relies on his 25 years of experience to help clients have an enjoyable retirement. He is a
Certified Financial Planner™ and Certified Investment Management AnalystSM (CIMA®) and has earned his Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®) designations. A lifelong resident of Cape May County, Eric resides in Seaville, NJ with his wife Chrissy and their sons ,CJ and Cooper, and daughter Riley.
