Index mutual funds and exchange traded funds can offer all-in-one exposure to the stock market through the indices they track. But there's another way to match the performance of a benchmark index without buying into funds: direct indexing.What Is Direct Indexing?"Simply put, it attempts to replicate the performance of an index by purchasing the underlying individual equities instead of using an ETF or mutual fund in an investor's portfolio," says Rob Cavallaro, chief investment officer at RobustWealth.Though the concept has been around for decades, it's only recently begun to move into the mainstream. Digital investing platforms and fractional share trading have made the direct index method more accessible to a broader range of investors, beyond just the ultra-wealthy.With more financial advisory firms and robo advisory platforms offering this option, it could give traditional index funds and ETFs a run for their money.How direct indexing works.The direct index advantage.It may not be right for every investor.How Does Direct Indexing Work?It may sound complicated but it's a simple enough concept."At its core, direct indexing is the idea of owning an index," says Michael Neuenschwander, a certified financial planner at Outlook Wealth Advisors in HoustonRather than purchasing a mutual fund that holds all of the stocks in the S&P 500, for example, investors can purchase shares of all 500 stocks individually. This is made easier through fractional investing."Fractional share trading allows very small amounts of money to be invested in each position, allowing even the smallest investor to participate, Cavallaro says." That's a boon for investors who want to own larger companies, such as Alphabet (ticker: GOOG, GOOGL) or Amazon (AMZN) but doesn't have thousands of dollars to tie up in a single share.Daniel R. Hill, president and CEO of D.R. Hill Wealth Strategies, says this approach hinges on the idea that owning all the securities in an underlying asset class will provide some premium above the index return."This concept was developed when the research showed that the active manager fails to beat the market the vast majority of the time, so investors have a higher probability of success if they just own the index," he says.The Direct Index AdvantageThere are several benefits this approach can offer over other investing strategies. The first is tax-efficiency, says Shana Sissel, senior portfolio manager at CLS Investments in Omaha, Nebraska. "With a direct indexing portfolio, the portfolio manager can go in and harvest tax losses at the individual position level for the client when the opportunity arises," Sissel says.This offers more control over gains and losses throughout the year, while still maintaining the risk-return profile of the benchmark the investor is attempting to match. It becomes easier to optimize tax outcomes and minimize the chances of receiving an unexpected tax bill for capital gains. With an indirect strategy, the entire fund would have to be bought or sold to harvest losses, offering a lower level of customization to investor needs and objectives.Customization also extends to building a portfolio that reflects individual values. "Investors and advisors can select individual securities that align with their ethical and moral beliefs or avoid securities that don't," Cavallaro says. The result is a completely personalized portfolio.Another advantage is reduced operating costs for the do-it-yourself investor who's trading securities from a chosen index themselves through a brokerage account. Kip Meadows, founder and CEO of fund administration firm Nottingham, says cost benefits are realized when the trading account is large enough to absorb transaction costs associated with making trades.When trading index mutual funds or ETFs, investors pay not only transaction costs but the individual expense ratios for each fund. The expense ratio reflects the annual cost of owning the fund, expressed as a percentage. Buying full or fractional stock shares individually avoids that cost.Finally, direct indexing can be a pathway to managing risk."Research shows that investors can reduce company risk by owning more companies," Hill says. "By owning the index instead of some lesser portion of the index one reduces the overall volatility of their portfolio."It May Not Fit Every InvestorWhen considering any new investment strategy, it's always important to look at the potential drawbacks. The first challenge associated with direct indexing is that it requires the willingness to be a hands-on investor."There is an intensive management aspect to it," Sissel says.Indexing directly may be fairly straightforward when buying securities for an index such as the S&P 500. But it can get more complicated when attempting to replicate something like the Russell 2000, where liquidity issues may exist with underlying assets, or an international stock index.Aside from that, the trading frequency may be higher, particularly if the stock market enters a volatile period. That could mean paying more in trading or management fees.Neuenschwander says this is true for both the DIY investor and one who indexes directly with the help of an investment firm or advisor. "If all you're getting for those trading and management fees is the risk and return of the index, the extra expenses may not be worth direct indexing," he says.Comparing transaction fees against fund expense ratios can put costs in perspective."With an index like the S&P 500, transaction costs for 500 securities, even at $5 per transaction, still total $2,500," Meadows says. "If your index portfolio is $250,000, that equals 1%, which is likely significantly higher than a comparable index fund or ETF."For that reason, experts often agree that direct indexing may be most appropriate for investors who have large after-tax investments. Smaller investors, on the other hand, or those who are newer to the stock market may continue to be better served by the simplicity and cost-efficiency of an index fund or ETF.There's also diversification to consider. Hill says investors should take time to understand how a particular index is cap weighted such as large cap versus mid cap or small cap indexes.The Dow Jones Industrial Average, for example, is composed of large cap, blue chip companies. An investor who indexes directly would need to ensure they're balancing out those large cap holdings appropriately elsewhere in their portfolio."For investors where direct indexing does fit, then the natural next step is to determine what combination of indices fit your goals and objectives," Neuenschwander says. That means keeping risk tolerance, risk capacity, which refers to the amount of risk needed to achieve investment targets, and overall portfolio diversification in view.
S&P 500
Market timing has been given a bad rap with the buy-and-hold crowd. This might be due to the abundance of research suggesting timing the market is nearly impossible. But there are times when timing the market works for investors. Many folks may not even realize that they are already timing the market.
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In its purest form, market timing is an investing strategy that buys and sells securities based upon clues as to future market performance. In contrast with a buy-and-hold investor, the best market timers attempt to beat the markets. There is a group of investors, called traders, that professionally or privately abide by market timing and employ a variety of tactics to frequently trade in and out of the markets, for profit.
But market timing might not be binary: You either time the market or you don’t. There might be ways for ordinary investors to time the market successfully. Here are a few instances when to time the market:
- Stock picks.
- Using valuation metrics.
- Picking asset classes.
- Timing with moving averages.
Stock Picks
“Instead of trying to anticipate which way the entire market is going to move, you are better served trying to identify the catalyst that can jump-start a particular company,” says Jack Murphy, chief investment officer at Levin Easterly Partners in New York.
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A long-term investor can evaluate a company’s fundamentals, understand the growth drivers and determine if the company’s valuation is fair or undervalued. Strong balance sheets and competitive advantage are important. If an investor can identify a catalyst that will propel a stock forward, he or she can take a contrarian view, time the purchase of an individual stock and make a profit, he says.
Using Valuation Metrics
The best market timers understand valuation.
“You can certainly estimate fair value for any asset and determine whether its current price is close to fair value, far above, far below, or somewhere in between,” says Steven Jon Kaplan, chief investment officer of True Contrarian Investments.
The Shiller P/E ratio, also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio, computes the price-earnings ratio of a company or market by dividing the price by the average earnings for the last 10 years, adjusted for inflation. This smooths out the impact of economic cycles on the metric. By comparing the average CAPE ratio with the current P/E ratio, investors can assess whether stocks or the market in is over-, under- or fairly valued.
Currently, the CAPE ratio is 31.72. That’s in contrast with the average metric of 16.69. In comparison, the minimum and maximum ratios are 4.78 (from December 1920) and 44.19 (from December 1999.)
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Kaplan believes that with the CAPE ratio nearly double its historical average, it’s wise to time the market and sell most U.S. assets. In reality, this is a somewhat drastic approach for the ordinary investor.
This doesn’t mean that the market can’t go higher, or that it will drop next month, but that eventually, the market is likely to revert to the mean P/E ratio. In other words, at some point, the market will drop in value and investors will lose a portion of their U.S. investment value.
Picking Asset Classes
Specific investment strategies and asset classes differ in their popularity. James Solloway, chief market strategist at SEI Investments, prefers to use asset classes to time the market.
When a particular asset class, such as small-cap stocks, has delivered a period of outstanding performance, reducing exposure to this asset class and using the proceeds to buy another asset with different characteristics can help reduce the level of risk in a portfolio,” Solloway says.
This strategy of market timing could work with sectors, such as technology or real estate. For example, during the recent U.S. bull market, international stocks have underperformed. A market timer might review valuations of various international or country-specific markets and uncover undervalued sectors to buy.
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Market Timing With Moving Averages
Jeff Klauenberg, founder of Klauenberg Retirement Solutions, abides by rules driven market timing. A popular market timing strategy among market timers uses the 200-day moving average, or DMA, to signal when to make portfolio adjustments.
A moving average shows the overall price trend for a stock or a particular market. Professional investors and technical analysts may use the 40-day and 200-day moving averages to define medium- and long-term trends.
When the shorter-term moving averages, such as the 50-day moving average, cross over the 200 DMA, this indicates a change in the long-term market direction, Klauenberg says.
For example, consider the SPDR S&P 500 ETF Trust (SPY), which is currently trading at $331. On Oct. 2, 2019, the fund’s price chart dipped below it’s simple moving average. Had it continued for more than a day, investors might have considered this a sign that the S&P 500 was due for a price drop.
Like many signals, the signal of the 50 DMA crossing the 200 DMA may signal a change in market direction from a bull to a bear market or vice versa. Other market timers might use the 100 DMA average crossing the 200 DMA to offer longer-term trend data regarding when a market reversal is in the works.
In practice, if the 50-day moving average moves below the 200-day moving average, investors might take this as an indication that stocks will be trending down and sell.
Like all forward predictions, there’s no certainty that this indicator is reliable all the time. Like all investment strategies there are proponents and detractors. Regardless of one’s thoughts about technical analysis, using moving averages will not guarantee future market direction.
Currently, the U.S. stock market is overvalued when compared with historical norms. Cash can be an ally in a market timing strategy. Although no one knows when the market will reverse course, or what will be the catalyst, it’s likely that at some time in the future there will be a drop in investment values.
Smart investors, who maintain a cash cushion, can time the markets so that after a decline in prices, the best market timers can buy up stocks on sale.
Ultimately, many ordinary investors are unknowing market timers. Rebalancing an asset allocation is a form of market timing. The common investment management strategy of determining a ratio of stock investments to bonds, like 60% to 40% and then rebalancing back to those percentages when stocks or bonds deviate from their desired ratio, is a form of market timing. When stocks outperform, investors will sell the overvalued asset and buy more of the undervalued.
Timing the market can be an effective tactic in certain circumstances. Unfortunately, since even the best market timers don’t know the future, it’s difficult to perfectly buy low and sell high every time.