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Debunking Myths About Direct Indexing vs. ETFs

Paul Gamble, CEO, 55ip

Many industry articles have highlighted the advantages of direct index investing versus index investing with ETFs, with some even going so far as to call direct indexing an “ETF killer” or calling for the “great unwrapping” of ETFs. While the benefits of direct indexing are well known, these articles and opinion pieces may be selling advisors and clients short on the benefits and advantages of index investing with ETFs.

Custom index investing with ETFs:
Simplicity. Tax management. Customization.

Simplicity for the advisor and client

The proliferation of ETFs in recent years has provided effective building blocks to help deliver low-cost index exposures not only at the aggregate level, but also across sectors, countries and regions. For example, the individual S&P 500 sector exposures can be delivered through 11 ETFs, typically with low expense ratios and often with no trading costs.

Direct indexing strategies, in contrast, typically require portfolio construction and management with hundreds of individual stocks. For the advisor, the more positions held, the more complexity there is in managing accounts and communicating with clients. Even with the outsourcing options in the marketplace, the advisor and client experience can be costly and cumbersome.

The relative simplicity of custom ETF index investing strategies makes them more manageable and scalable for advisors, and the trading cost advantages make them more accessible across their client base, particularly for smaller accounts.

Well-suited to active tax management

Active tax management, usually in the form of tax-loss harvesting (TLH), can provide improved client outcomes through after-tax returns. TLH is typically achieved by selling specific stocks at a loss (e.g., Pepsi) to offset or defer capital gains taxes while buying similar replacement stocks (e.g., Coca-Cola).

Direct indexing advocates will often compare the benefits versus investing in a single aggregate ETF, such as SPY or IVV. This is not an apples-to-apples comparison. The explosion of low-cost and liquid ETFs allows for active tax management with similar benefits and some significant advantages compared to direct indexing implemented with stocks:

  • TLH – TLH can be delivered though industry sector, country and region ETFs, providing ample opportunity to harvest losses when markets are down or volatile.
  • Tracking error – ETFs enable TLH with potentially lower tracking error than individual equities when substituting positions.
  • Householding – ETF portfolios can be especially helpful in providing TLH and managing wash sales for similar securities owned across multiple household accounts.
  • Asset classes – Direct index strategies are typically limited to equity investing. ETFs allow for portfolio management and harvesting of any asset class covered by the universe of ETFs.

Customization for factors, ESG and client objectives

Direct indexing proponents will rightly highlight that index exposures can be customized for factor exposures and ESG investing. Again, the proliferation of ETFs provides similar capabilities and some advantages:

  • Factors – Technology is available today to apply factor tilts to sector exposures or select from the many factor ETFs in the marketplace.
  • ESG – Like factors, intelligent technology can customize exposures toward or away from industries based on ESG scores or select from the growing number of ESG ETFs.
  • Client objectives – ETFs provide the unique ability to blend index exposures across multiple equity and fixed income asset classes, to align with client objectives and risk tolerance.
Conclusion

Custom index investing by combining ETFs with intelligent customization and automation, provide greater flexibility, simplicity and access than direct indexing with stocks – leading to a more streamlined experience for advisors and the potential of better outcomes for more investors.

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