Direct Indexing vs ETF: Which Is Better?

So you’re thinking of diversifying your portfolio, and two popular options stand out: direct indexing and ETFs. But which one is better for you? 

Direct indexing offers a tailored approach. You own and manage individual stocks within an index, ideal for high-net-worth individuals seeking precise control over their investments and tax management. On the other hand, ETFs provide instant diversification, lower fees, and are accessible to retail investors. 

Which route should you take? This article will explain the key differences and benefits of each to help you make the right choice for you.

What is direct indexing?

Direct indexing involves purchasing individual securities that replicate an index, so you can own the underlying stocks rather than shares of a pooled investment vehicle. This investment strategy provides you with greater control and flexibility in managing your portfolio.

Directly owning the stocks that make up an index enables you to tailor your holdings to align more closely with your financial goals and personal values.

One of the key benefits of direct indexing is its potential for tax efficiency. You can manage capital gains and losses at the individual stock level, which may lead to a more favorable tax outcome compared to traditional index funds.

Also, direct indexing allows for customization, such as excluding or underweighting certain stocks based on ESG considerations or other personal preferences.

Automated direct indexing services have also emerged, which has streamlined the process of managing a diverse portfolio of individual stocks. This makes direct indexing more accessible to high-net-worth individuals who want to take advantage of its unique benefits without the complexity involved in direct management.

What is an ETF?

After exploring the benefits and mechanisms of direct indexing, let’s explain another key option available to investors: Exchange-Traded Funds (ETFs).

An ETF is an investment fund that tracks an index, commodity, or basket of assets and is traded on stock exchanges like individual stocks.

When you buy an ETF, you’re fundamentally buying a share in a pool of securities. This pool is designed to replicate the performance of a specific index, such as the S&P 500. It’s worth noting that it’s completely normal to own more than one type of ETF, and the number of ETFs you should own will ultimately depend on your individual goals.

Unlike direct indexing, where you own individual stocks, with an ETF, you own shares of the fund, not the underlying assets. This structure allows for instant diversification and reduces your exposure to individual security risk.

ETFs are known for their liquidity and flexibility, as they can be bought and sold throughout the trading day at market prices. They also typically have lower management fees compared to actively managed funds, which makes them a cost-effective option for long-term investors.

While ETFs offer broad market exposure, they may limit direct tax management options compared to strategies like direct indexing.

Key differences between direct indexing and ETFs

Direct indexing allows you to own individual stocks, giving you total ownership and control, whereas ETFs represent indirect ownership through shares of a fund. This distinction is vital because it influences how you can manage your portfolio, especially when it comes to tax strategies.

Unlike ETFs, which follow set rules and compositions, direct indexing offers the flexibility to customize your portfolio according to your personal preferences and tax strategies.

Direct indexing facilitates tax-loss harvesting at the individual stock level, enabling better capital gains management compared to ETFs, where loss harvesting occurs only upon complete position sale.

However, direct indexing typically requires higher investment minimums, ranging from $250,000 to $500,000, while ETFs are more accessible due to lower capital requirements.

Also, we should mention that direct indexing may incur higher management fees than ETFs due to the active management of individual securities. With direct indexing, you’ll typically face management fees that range from 0.30% to 0.75% annually. This contrasts sharply with ETFs, which can have expense ratios as low as 0.03% to 0.25%. 

Direct indexing management fees are generally higher than ETFs, but the tax benefits and customization may outweigh these costs for high-net-worth investors.

Performance and risk considerations

Investing in the stock market involves weighing various strategies, each with its unique risks and performance considerations. 

Direct indexing provides you with greater control over individual stock performance. You can manage risk by adjusting specific holdings based on market conditions. This can be particularly beneficial for investors who are able (and willing) to handle the complexity of managing individual stocks.

However, direct indexing may present higher volatility due to concentrated individual stock holdings compared to the inherent diversification of ETFs, which spread risk across a basket of securities.

Risk management techniques in direct indexing can lead to greater long-term growth potential by enabling you to tailor your portfolio to your specific needs and market conditions. 

ETFs maintain simplicity and lower management fees, which appeals to those prioritizing ease of investment.

Your ability to manage risk and your willingness to handle complexity will influence your choice between direct indexing and ETFs. Effective risk management in direct indexing can yield better performance but requires more active involvement.

Who should choose direct indexing?

Direct indexing is a particularly viable option for high-net-worth individuals and sophisticated investors who seek enhanced tax management strategies and personalized control over their portfolios. It can be particularly helpful to have a personal banking assistant to help you execute the desired direct indexing strategy.

This investment strategy allows you to own individual stocks directly. You have greater flexibility compared to ETFs and mutual funds. With direct indexing, you can customize your portfolio to align with specific goals or ethical considerations, such as ESG criteria, and systematically realize capital gains and losses from individual stocks to optimize tax outcomes.

If you’re an investor with significant assets, direct indexing can be particularly beneficial. It allows for tax-loss harvesting at the individual stock level. You can potentially boost after-tax returns by up to 1% annually.

Also, if you anticipate significant capital gains taxes or desire active management and personalized control, direct indexing may be more suitable than ETFs. 

Who should choose ETFs?

Retail investors seeking affordability and simplicity may find ETFs more appealing.

If you’re looking for a low-cost way to invest with minimal capital requirements, ETFs are a good choice. They allow you to trade with small amounts of money and even accommodate fractional shares, so they’re accessible to a broader range of investors.

The ease of trading throughout the day also makes ETFs particularly suitable if you’re seeking liquidity and flexibility in accessing your investments. Unlike direct indexing, which requires more active management, ETFs provide instant diversification and exposure to a broad range of assets, reducing the risks associated with single-stock investments.

Also, ETFs generally come with considerably lower management fees compared to direct indexing.

If you favor a hands-off approach and simplicity in your investment strategy, ETFs are an efficient option. They don’t require the same level of active management as direct indexing, and are ideal for passive investors. 

You may also want to look into discretionary fund management if you want even more of a hands-off approach.

The bottom line

When choosing between direct indexing and ETFs, consider your individual financial goals and circumstances. One isn’t necessarily better than the other, objectively speaking, but one may suit you better than the other.

Direct indexing offers personalized control and tax management. It’s suitable for high-net-worth investors who seek customized strategies. Conversely, ETFs provide instant diversification, lower fees, and are more accessible to retail investors.

Your choice hinges on whether you prioritize tax efficiency and customization or a low-cost, hands-off approach. 

Source: https://coincodex.com/article/47775/direct-indexing-vs-etf/