Direct Indexing: The Best of Both Worlds?

Written by: Thomas Kostigen

Tesla is joining the S&P 500 index on December 21st, and analysts have mixed reactions: the forecast 12-month high for the stock is 800 while the low is 40. Quite a difference.

Can’t decide who is on the right side of that trade and would like to opt out of owning Tesla at all in your portfolio? You won’t have to bail on your index fund. Direct indexing allows you to zap certain stocks out of an index while retaining the rest of the basket.

Many people utilize direct indexing to exclude companies that don’t align with their values (e.g. oil & gas, casino, gunmakers, etc.), or which may be too costly to own outright. (See MPFA’s primer on direct indexing here.) But some investors may want to utilize direct indexing like they would a managed account—getting all the benefits of customization along with professional money management. Wealthy individuals and institutions have been investing this way for decades because they can afford the high investment minimums that usually come along with customized investment management products. Direct indexing takes the high entrance fees out of the equation and gives average investors the same opportunities as high net worth individuals.

A good financial advisor is recommended to act as counselor for direct indexing. And both professional financial advisors and investors are seeing value in the strategy. As evidence of the growing trend: last month BlackRock, the world’s largest money manager, acquired Aperio, which assists financial advisors with direct indexing. Earlier this year, Morgan Stanley bought another direct indexing specialist, Parametric Portfolio Associates, into its fold. Both events bump the profile of direct indexing and provide larger platforms for its marketability. Soon, you’ll likely start seeing sales materials arriving in your inbox along with your financial statements touting the benefits of direct indexing.

As the Financial Times recently wrote: “Imagine a 401(k) where there’s no investment menu of stock funds. Instead, you get to make one that aligns with your values. You could begin by knocking out oil drillers or gun manufacturers, or subtracting companies one by one depending on which ones have crossed you (or the world) lately. And when you’re done, you — and not a mutual fund — own individual pieces of every other security that you’re not beefing with, whether personally or as a citizen of the world. Some of the biggest names on Wall Street can conjure up this tantalizing prospect, which is called direct indexing.”

The rationale for buying index funds is that investors rarely beat the index in terms of returns. Exchange traded funds have exploded in popularity loosely based on this concept. Still, manipulating an index too much defeats the purpose of the index as you lose the diverse nature of the basket.

For people who want to incorporate their values into an index without losing the power of the index itself, direct indexing may be the way to go. Of course, the composite of the values you wish to embrace within an index is purely your own. And while environmental, social and governance (ESG) values are en vogue, let’s not forget there are other value systems investors embrace. “Sin” stocks were hot for a time, and may be again.

The point is that whether a saintly or sinning investor, direct indexing gives you the choice of not having to conform to an all-sum standard. Given the divisive times we are in, that may be attractive to all.

Related: 3 Timeless Lessons from Investing in Apple