Q&A: Why Direct Indexing Is the Future of Index Investing

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Index funds have helped democratize investing, empowering virtually anyone to own a piece of the S&P 500. But traditional index investing leaves one big element to be desired: customization.

a group of people sitting at a table using a laptop computer: African American financial advisor having a meeting with a couple and writing their financial reports in her office. © (Getty Images) African American financial advisor having a meeting with a couple and writing their financial reports in her office.

If you own a share of an S&P 500 index fund, you can’t select a pool of individual companies or their weightings. Your only options are to take the pool as it is or leave altogether and create your own pool. This latter option, known as direct indexing, is becoming increasingly popular.

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Rather than buying shares of an index fund, direct indexers replicate the index in their own portfolios by buying shares of each of the index’s holdings – or at least, the holdings that the investor actually wants. If you want to invest in the S&P 500 but don’t want to own Tesla (ticker: TSLA), you can create your own S&P 500 minus TSLA with a direct-index portfolio.

While it’s been around for several decades, direct indexing is only now edging into the limelight. To learn more about this strategy, what drives its rising popularity and how it can help investors and advisors navigate uncertainty, we spoke with Brian Langstraat, CEO of Parametric, a firm that was direct indexing long before it became cool. Here are edited excerpts from that interview.

What do you think is driving the increased interest in direct indexing?

The increased interest is being driven by three fundamental shifts in the industry. First is the move to passive investment. Second is an emphasis on tax management. And third is an emphasis on environmental, social and governance, or ESG-focused, investing.

The struggle of active managers as a group to consistently outperform the market after fees and taxes is well documented. Exchange-traded funds, as largely passive investment vehicles, have certainly seen tremendous growth due to this trend. Direct indexing opens a different investing landscape, one that delivers the benefits of a passive investment approach with the power of customization.

Tax management, meanwhile, is one of the most productive activities in investment management. If you can reduce an investor’s tax bill by deferring capital gains, transforming them from short-term to long-term characterization, offsetting them with carefully realized losses, or transferring appreciated securities in or out in-kind, you preserve capital in the account that can remain invested. We estimate, and have many live examples to support, that prudent tax management can create as much as 1% to 2% of after-tax performance on an annual basis – real money.

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Last, but of course not least, is an emphasis on ESG-focused investing, also known as responsible investing. This area has seen a surge of interest. For example, the number of separate accounts Parametric manages with ESG customization has increased more than sevenfold over the last six years. Creating portfolios that align with or express an investor’s values is a powerful draw.

Why is customization such an important element of direct indexing?

Customization provides flexibility, personalization and tax efficiency beyond what can be achieved through ETFs or mutual funds, namely by managing the tax impact of current holdings, incorporating investor restrictions or preferences and facilitating tax-efficient charitable gifting programs – all while carefully managing ongoing year-round tax-loss harvesting.

Given the levels of uncertainty we’re currently experiencing, is direct indexing a good approach for advisors and their clients? Or is there a better strategy available?

Direct indexing gives investors and advisors a level of control not available in other vehicles or approaches. As investors and their advisors face uncertainty, customization and flexibility become paramount. I have no doubt we added as much value to clients and advisors in 2020 as in any of the past 30 years we have been doing this type of investing.

What trends are you seeing in the market and among investors? Can you share some of the recent investments Parametric is making as the world navigates the results of the recent election and pandemic?

It is hard to imagine a more dramatic roller coaster ride for investors than 2020. We had a once-in-a-century pandemic, protests against racial injustice, a presidential election, and the S&P dropped more than 33% in March and hit all-time highs in December. No one could have foreseen any of this.

What this tells us is that the market is impossible to predict, so humility is key. This is why we’ll continue to focus on our systematic, scientific approach to investing. In 2021, we will continue to make significant investments in research, technology and innovations to ensure we continue to deliver on our investment commitment to our clients.

With our history and our breadth and depth across equity, fixed income and derivative management, we have the opportunity to remain a market leader. Of particular note, and somewhat driven by the pandemic, is our emphasis on digital interactions with advisors and clients to support and facilitate the custom accounts we offer. Digital interaction – before, during and after the pandemic – offers powerful and convenient ways for advisors to design, implement and service their customized portfolios.

Do you have any predictions for what advisors and investors can expect in 2021?

If 2020 has taught us anything, it is to not be in the prediction business because everything is unpredictable. I do think it is safe to say that U.S. tax policy and tax rates will be an important 2021 topic for investors and advisors. It is also clear to us that investors will continue to seek ESG solutions and integration in their portfolios. The work advisors do for their clients will remain incredibly valuable.

Copyright 2020 U.S. News & World Report

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