The Pros and Cons of Direct Indexing

Christine Benz: Hi, I'm Christine Benz for Morningstar. Is direct indexing the next big frontier for investors? Joining me to discuss the pros and cons of direct indexing, as well as what it is, is Joel Dickson. He's Vanguard's global head of advice methodology.

Joel, thank you so much for being here.

Joel Dickson: Great being here, Christine.

Benz: Joel, direct indexing is all the buzz these days. First, let's just talk about what we're talking about when we say direct indexing.

Dickson: I think direct indexing is this sort of broad concept. It's actually been around in the investment industry for a couple of decades now. But it's basically, can you in essence recreate a mutual fund or a diversified portfolio with the individual components, the individual pieces? And can it be done in say, a more customized or personalized manner for your objectives as an investor as opposed to kind of being in a broadly diversified portfolio that is the same for everyone? So that's the usual thing that we talk about with with direct indexing.

Benz: Let's talk about some of the reasons why that would be valuable to investors. One I think may be a good illustration would be to talk about someone who cares about environmental, social, and governance factors--or maybe just one factor, like, I don't want to own any tobacco stocks. The advantage of direct indexing is that you could sort of tailor that portfolio to the person's own particular preferences.

Dickson: Absolutely. And that's certainly a possibility. And one of the main ways that we talk about customizing portfolios, one of the things that certainly has been found in the industry, is everyone's definition of ESG and what is valuable to them or what they don't like, and so forth, is different. And so, it's really hard to all be in the same portfolios; somebody has issues with tobacco, or another one with firearms, or another one with weapons, and so forth. But not everyone has all of those together. So what you end up dealing with is in a commingled portfolio is you try to just sort of get close to meeting everybody's needs. If you can customize it to your particular beliefs and situations, then it might better represent your values in your investing portfolio. And that could then be done on a personal level.

Benz: Another potential benefit is that you could use the portfolio to help address odd things that someone might have going on in their financial lives. So maybe they have a lot of their wherewithal riding on the sector, where they work, where they work in the tech sector, and they also have company stock in that tech company. The portfolio could help address that issue.

Dickson: In theory, it certainly could. I mean, you think about an overall optimization, if you will, of what's the right overall portfolio, given the constraints and the situation that you're in, and maybe it is, you've inherited grandma's or grandpa's IBM stock from however long ago, and that's a significant piece of your overall portfolio. Well, that security in itself might be a significant risk in the context of your overall portfolio, you have a lot of, single-stock type risk. But you might be able to diversify around that or complete the portfolio that we talk about. And one way to do that might be through other securities. It may also be, you could use diversified funds and ETFs as well to complete around it, but recognizing what the exposure is that you are trying to mitigate in terms of the risk in your overall portfolio. And direct indexing may be one way to do some of that.

Benz: And tax issues might be another reason that if you have that extra customization, there's more ability to do tax-loss harvesting and other strategies.

Dickson: Yes, I mean, there's certainly, if you have any individual securities that are more volatile than let's say the market as a whole, for example. Then, stock A may go up, stock B may go down, even though the market itself is doing whatever, you know, up 5%, but one stock might be up 20% and another down 20%. You'd have some ability to realize losses to maybe offset gains in other parts of your portfolio. You might have that ability to realize a greater amount in an individual security portfolio. Similarly, if you're engaging in other sort of tax planning strategies with gains, the more gains that you have that could potentially be used, for example, for charitable contributions, flow through in estate and so forth, and you might have some tax benefits in doing so. It's not clear though, however, if you're already engaging in a very tax-efficient portfolio construction.

Benz: Like owning a total market ETF.

Dickson: Exactly. I mean, you're probably not having a lot of gains that you would otherwise want losses to offset and so forth in terms of realized gains. So, it's not clear how much benefit it has. There's a lot of numbers out there by proponents that would say, oh, several hundred basis points. You have to be very careful about the assumptions that are being used in that. And often it's that any loss can be offset against a gain in that year that the loss is realized at the highest tax rate. That's often not the case, because like I said, most people that are investing tax-efficiently aren't realizing gains on a regular basis. So, there is certainly additional value from a tax standpoint to realize losses in individual security portfolios. Whether those losses translate into higher or significantly higher after-tax returns I think is a little bit more of an open question.

Benz: Let's get back to that customization. It seems like from a lot of standpoints that could be really attractive, but there's a trade-off, and so the big one would seem to be with increased customization would come some extra costs. So how should investors think about that?

Dickson: At the end of the day, you want to try to build a diversified portfolio, minimize those things that are what we would say in the investment world are uncompensated risks, right? And uncompensated risks, are you taking more volatility in the portfolio than you need to that could otherwise be diversified away? And so when you think about customization, the costs that come with that, do you have enough resources to be able to diversify a portfolio effectively to achieve what you want in terms of your values or the custom portfolio that you want, but at the same time, not expose yourself to undue risk? I mean, the fact is, you can get a total market U.S. equity portfolio for 4 basis points or so in the marketplace these days. So, are you saving that much in management fee by doing that a different way? Maybe not. But we are seeing now more and more with reductions of commissions--and in fact now no-commission trading for online trades in most places at this point--the ability to build and trade individual security portfolios that might have somewhat lower costs than let's say they did even a couple of years ago. And so that's reduced the cost of assembling these. You still have oftentimes issues around being able to build individual security positions, because a lot of places you still have to buy in whole share increments, whether it's ETFs or whether it's individual securities and so forth. And for smaller balanced portfolios, then having 100 stocks may be a bit of a challenge there, for example, to actually get a well-diversified portfolio. I do think the other component is just kind of the ongoing maintenance.

One of the big things that you get with commingled portfolios, you kind of have a portfolio manager that is managing the corporate actions, that is managing cash flows and trading, and so forth that may not be there in the same way of the direct index portfolio. So, there's a lot more monitoring and maintenance that maybe you as an investor, or somebody that is trying to build customized portfolios at scale, has to accomplish that I think sometimes isn't well-understood.

Benz: That leads me to my next question. Vanguard of course sells a lot of different products. Has Vanguard thought about entering this direct indexing space to make it easier for investors to customize their own baskets?

Dickson: We've clearly done a lot in terms of, especially recently, for example, on the ESG front, in creating portfolios and in actually even providing more individual type or narrower type tools like factor-based portfolios and so forth for greater customization. In terms of the direct indexing itself, we have and will continue to look at direct indexing other types of products, structures, and strategies that we do think could potentially benefit clients. There are no immediate plans that we've announced or anything like that, but certainly we look at a lot of things in our product offering suite. And, it would be disingenuous for me to say we haven't looked at and thought about direct indexing and customization at scale for clients.

Benz: Joel, always great to get your insights. Thank you so much for being here.

Dickson: Thank you for having me, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.