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.
