The debate has been raging in the investment community for decades: active or passive investment? Publications from Bloomberg to Forbes have weighed in, picking their sides, and cautioning investors that there is no clear winner, and that each choice comes with its own set of advantages and risks.
Let’s break down the differences between the two methodologies and discover how Direct Indexing combines a passive investment strategy with the potential tax benefits of active management.
Active vs Passive Management
Active management is broadly defined as any investment strategy that involves buying and selling decisions in a portfolio in an attempt to outperform the market. Outperformance of a market is called “alpha”. Passive management, on the other hand, is a term broadly associated with an investor's attempt to mirror the return of the market. Achieving market return in this context is called “beta”.
In 1973, economist Burton Malkiel published A Random Walk Down Wall Street, a book that argued against active management and claimed that investors would be better off investing in index funds that generate average returns by combining a broad swath of the market. This hypothesis has been largely validated, with the majority of actively managed funds underperforming their benchmarks, according to 2020 data from the S&P Global. Today, passive investment represents over 50% of publicly traded assets in U.S. equity funds.
But active management is making a comeback in the form of hybrid investment models. Direct Indexing in particular combines a passive investment style with active characteristics such as portfolio customization and active tax management.
The Best of Both Worlds
Direct Indexing enables investors to buy individual stocks in an index rather than buying a fund in its entirety. This approach allows investors to enjoy the benefits of passive investing, specifically low costs and market-like returns, with the added benefit of customization and year-round tax loss harvesting to help maximize after-tax returns. For larger HNW clients with existing stock positions, Direct Indexing also provides the ability to absorb holdings in order to minimize capital gains.
Adhesion Wealth is a leading provider of index-based, tax-advantaged investment solutions. Our Unified Managed Account capabilities are the foundation of our Direct Indexing services, allowing a Direct Index to be placed at the core of an account, with satellite holdings wrapped around it. The Adhesion Investable Index Series shows how our Direct Index strategies can provide low-cost, tax-aware portfolios that focus on tax-loss harvesting while demonstrating index-like tracking characteristics.
The debate between active and passive investment strategies will continue for years to come, but hybrid options are uniquely attractive to both advisors and investors in the current financial climate. Forward-thinking RIAs have begun to use Direct Indexing to offer their clients a personalized option designed to fit their preferences, maximize tax alpha, and provide index-like returns.