Retired Money: Direct Indexing has drawbacks but a hybrid DIY strategy may have merits

Image courtesy Photo by Ruben Sukatendel

My latest MoneySense Retired Money column looks at a trendy new investing approach known as “Direct Indexing.” You can find the full column by clicking on the highlighted headline: What is direct indexing? Should you build your own index?

Here’s a definition from Investopedia : “Direct indexing is an approach to index investing that involves buying the individual stocks that make up an index, in the same weights as the index.”

When I first read about this, I thought this was some version of the common practice by Do-it-yourself investors who “skim” the major holdings of major indexes or ETFs, thereby avoiding any management fees associated with the ETFs. It is and it isn’t, and we explore this below.

Investopedia notes that in the past, buying all the stocks needed to replicate an index, especially large ones like the S&P 500, required hundreds of transactions: building an index one stock at a time is time-consuming and expensive if you’re paying full pop on trading commissions. However, zero-commission stock trading largely gets around this constraint, democratizing what was once the preserve of wealthy investors.   According to this article that ran in the summer at Charles River [a State Street company], direct indexing has taken off in the US: “ While direct index portfolios have been available for over 20 years, continued advancement of technology and structural industry changes have eliminated barriers to adoption, reduced cost, and created an environment conducive for the broader adoption of these types of strategies.”

These forces also means direct indexing can be attractive in Canada as well, it says. However, an October 2022 article in Canadian trade newspaper Investment Executive suggests “not everyone thinks it will take root in Canada.” It cast direct indexing as an alternative to owning ETFs or mutual funds, noting that players include Boston-based Fidelity Investments Inc, BlackRock Inc., Vanguard Group Inc., Charles Schwab and finance giants Goldman Sachs Inc. and Morgan Stanley.

An article at Morningstar Canada suggested direct indexing is “effectively … the updated version of separately managed accounts (SMA). As with direct indexing, SMAs were modified versions of mutual funds, except the funds were active rather than passive with SMAs.”

My MoneySense column quotes Wealth manager Matthew Ardrey, a vice president with Toronto-based TriDelta Financial, who is skeptical about the benefits of direct indexing: “While I always think it is good for an investor to be able to lower fees and increase flexibility in their portfolio management, I question just who this strategy is right for.” First, Ardrey addresses the fees issue: “Using the S&P500 as an example, an investor must track and trade 500 stocks to replicate this index. Though they could tax-loss-sell and otherwise tilt their allocation as they see fit, the cost of managing 500 stocks is very high: not necessarily in dollars, but in time.” It would be onerous to make 500 trades alone, especially if fractional shares are involved.

Ardrey concludes Direct indexing may be more useful for those trying to allocate to a particular sector of the market (like Canadian financials), where “a person would have to buy a lot less companies and make the trading worthwhile.”

A hybrid strategy used by DIY financial bloggers may be more doable

I would call this professional or advisor-mediated Direct Indexing and agree it seems to have severe drawbacks. However, that doesn’t mean savvy investors can’t implement their own custom approach to incorporate some of these ideas. Classic Direct Indexing seems similar but slightly different than a hybrid strategy many DIY Canadian financial bloggers have been using in recent years. They may target a particular stock index – like the S&P500 or TSX – and buy  most of the underlying stocks in similar proportions. Again, the rise of zero-commission investing and fractional share ownership has made this practical for ordinary retail investors.

Why would you want to do this? If you’re an investor with significant taxable investments (non-registered), then the ability to customize your stock ownership may be a way of maximizing Tax Loss Harvesting. It’s also a way you can do your own version of ethical investing: declining to buy, for example, tobacco stocks or Defense stocks or any other specialized type of stock that offends your sensibilities. Conversely, it’s a way to double down on high-conviction stocks such as perhaps the tech giants, or energy stocks. With the S&P500, you would endeavour to have the 11 major economic sectors represented and in similar proportions. But you wouldn’t have to slavishly imitate the index: after all, if that’s what you want, you can more easily just buy an index fund or ETF.

Morningstar suggests DI’s ability to customize portfolios is mostly “spin.” It then suggests a version of the hybrid DIY approach to DI that I believe many financial bloggers already espouse. “But there’s no point in doing so through direct indexing,” it argues, “Instead, buy an index fund to anchor the portfolio, then trade individual equities on the side. Using two investment buckets rather than one is both cheaper and cleaner.”

The MoneySense column looks at how two Canadian financial bloggers often employ a hybrid strategy of using both ETFs and skimmed “high-conviction” picks drawn from ETF portfolios: Mark Seed of My Own Advisor, and Dale Roberts of Cutthecrapinvesting, who is also a MoneySense colleague. This diluted form of Direct Indexing is a way to lower fees and customize your own index.  Seems to me the best of both worlds!

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