By Stephen L. Thomas | November 2, 2023 | In
Index investing has gained significant popularity among investors seeking a passive approach to wealth accumulation. It offers broad market exposure and is known for its potential to deliver consistent returns over the long term. While traditional index investing through pooled funds like mutual funds and exchange-traded funds (ETFs) remains a popular choice, direct indexing with individual securities has emerged as an alternative. Let’s compare these two approaches to help investors make an informed decision.
1. Diversification
Pooled Funds
Mutual funds and ETFs provide instant diversification by holding a basket of securities that replicate an index. This diversification helps mitigate the impact of individual stock performance on the overall portfolio.
Direct Indexing
Direct indexing allows investors to build a portfolio using individual securities to replicate an index. While it offers greater control over the selection of specific stocks, it requires careful consideration to achieve adequate diversification.
2. Customization
Pooled Funds
Mutual funds and ETFs are pre-designed investment vehicles, offering limited customization options. Investors can choose funds based on the index they track but have little control over the individual securities held within.
Direct Indexing
Direct indexing provides a higher degree of customization. Investors can tailor their portfolios by excluding specific stocks, incorporating personal preferences, or incorporating environmental, social, and governance (ESG) criteria. This level of customization can align the portfolio more closely with an investor’s goals and values.
3. Costs
Pooled Funds
Mutual funds and ETFs charge expense ratios, which represent the fund’s management fees and operational costs. These costs can vary among funds but are generally low. However, investors should be aware of additional transaction costs, such as brokerage commissions and trade spreads for buying or selling fund shares.
Direct Indexing
Direct indexing eliminates the need to pay expense ratios associated with pooled funds. Direct indexing is typically more cost-effective for larger portfolios where the benefits outweigh the transaction costs.
4. Tax Efficiency
Pooled Funds
Mutual funds and ETFs distribute capital gains to their shareholders, which can create tax liabilities, even for investors who haven’t sold their fund shares. Additionally, investors have no control over the timing of these distributions, potentially leading to higher tax bills.
Direct Indexing
Direct indexing offers enhanced tax efficiency. Investors can selectively harvest tax losses by selling individual securities at a loss, offsetting gains in other parts of their portfolio. This flexibility can result in reduced capital gains taxes and increased after-tax returns.
5. Minimum Investment
Pooled Funds
Mutual funds and ETFs typically have minimum investment requirements, which can vary depending on the fund and share class. These minimums are usually quite low, allowing smaller investors to access a diversified portfolio that otherwise wouldn’t be available.
Direct Indexing
Direct indexing often requires a much larger minimum investment than a pooled fund. The size of the initial investment will depend on which index the strategy is seeking to replicate. While this makes direct indexing more complex than just buying an index fund, the advantages of direct indexing make this the preferred method of index investing for affluent investors.
Both pooled funds and direct indexing offer distinct advantages and considerations. Pooled funds provide instant diversification, lower transaction costs, and simplicity, making them suitable for most investors. On the other hand, direct indexing offers customization, potential tax advantages, and the ability to align investments with personal values. It is more suitable for investors with larger portfolios who seek greater control and are willing to manage individual securities. Ultimately, the choice between these two approaches depends on an individual investor’s goals, preferences, and circumstances.