In recent years, direct indexing has gained momentum, particularly with the rise of FinTech companies. It represents a newer approach to investing compared to traditional ETFs and mutual funds, offering increased customization and the potential for higher returns.
What is Direct Indexing?
ETFs and mutual funds typically hold a portfolio of stocks that mirror an index, such as the S&P 500, comprised of the top 500 US stocks. Direct indexing, on the other hand, involves replicating this portfolio by directly purchasing the underlying stocks.
Advantages
The primary benefit of direct indexing lies in its capacity for portfolio customization. This entails adjusting the weighting of specific stocks or sectors. For instance:
- You can opt to exclude all tobacco companies for personal reasons.
- You can choose to increase the weighting of Apple due to your affinity for their products.
Another advantage is tax loss harvesting. While some companies in the index may thrive, others may falter, resulting in capital losses. ETFs cannot pass these losses to their investors, but with direct indexing, you can benefit from them.
Downsides
The main drawback of direct indexing is its cost. Operating at a smaller scale, direct indexing tends to be more expensive than ETFs. Typical ETF management fees hover around 0.05%, whereas direct indexing costs can range from 0.25% with a robo-advisor to 1% if managed by a traditional financial advisor.
Conclusion
For most portfolio sizes, the advantages of direct indexing may not justify its use over ETFs due to the higher costs involved. However, if you really value the benefits of portfolio customization, direct indexing could be worthwhile.
Direct indexing for expats
For certain US expats, direct indexing may offer particular advantages instead. For instance, it could provide a viable investment avenue in situations where accessing US ETFs proves challenging, because many brokers don’t offer US ETFs to people with residency outside the country. Additionally, in countries like Italy, direct indexing might offer greater tax efficiency compared to holding US ETFs in your portfolio.
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