Over the past three decades, ETFs have grown to become a staple for millions of investors, thanks to their ability to provide easy access to a broad range of diversified securities. While ETFs may be among the most popular funds, they certainly aren’t the only option — especially for those investors who are interested in tracking index performance.
Direct indexing is another, lesser-known option that may suit some investors better, depending on their goals. Let’s take a look at both, as you consider whether one (or both) may have a place in your portfolio.
What are ETFs?
An ETF, or exchange-traded fund as it’s formally called, is a type of investment security that can be traded like a stock. The difference, however, is that an ETF holds a basket of stocks and securities within it — as opposed to representing just one particular company or asset.
ETFs are generally used to mimic an index, like the S&P 500, or follow a particular investment strategy, such as generating income.
ETFs can help investors diversify their portfolios with a pool of securities, without the time and hassle of individual stock-picking and management. Rather, investors have the option to simply buy and sell shares of an ETF. Just keep in mind that when you’re purchasing an ETF, you own shares of the actual fund — meaning you do not own shares of each individual stock held within the ETF.
Are all ETFs created equal?
Traditionally speaking, ETFs have been assumed by many to be passive investments. This makes sense, as they were originally developed to mirror the performance of certain indices.
Recently, however, active ETFs have gained an impressive amount of popularity in just a few short years. Between just 2020 and 2023 alone, the number of total active ETF assets nearly tripled.1
With actively managed ETFs, portfolio managers and analysts are working behind the scenes to determine what securities should be included (or removed) from the ETF on a recurring basis. As such, active ETFs tend to be a more expensive option for investors than passively managed ones.
In terms of which particular securities are held by the ETF, investors have plenty of options including:
- Industry ETFs: Tracks a particular stock sector, such as energy.
- Bond ETFs: Can include any type of bond (government, municipal, corporate) and offer an income distribution component.
- Commodity ETFs: Focuses on a particular commodity, like gold.
- Currency ETFs: Tracks prices of multiple currencies across the globe.
ETFs vs. Mutual Funds
Most conversations regarding ETFs inevitably segue into a comparison of their most similar counterpart, mutual funds. We won’t spend too much time here, but as a brief recap, mutual funds can also provide investors with exposure to a diversified set of securities.
Multiple investors pool money together into a mutual fund, which a fund manager takes and invests in a basket of securities (typically stocks and bonds). Similar to ETFs, mutual funds are typically either passive (known as index funds) or actively managed. Index funds, just as it sounds, are designed to mirror the performance of a certain index, while actively managed funds work to beat the market through active trading. Again, actively traded funds tend to come at a higher cost to the investor.
The primary difference between ETFs and mutual funds is their trading frequency. ETFs are able to be bought and sold throughout the trading day, while mutual funds are only traded once a day — and that’s after the market has closed. As a result, ETF prices are subject to fluctuations throughout the day, whereas mutual fund investors will receive the same price for the entirety of the trading day.
What is direct indexing?
Direct indexing often feels like the lesser-known third option investors can consider when trying to replicate the performance of an existing index within their portfolio. In reality, direct indexing may be an attractive opportunity for those who desire more flexibility than an ETF or mutual fund can provide. Investors may also be able to benefit from some additional general tax-saving opportunities.
But what is direct indexing, and how does it differ from an ETF or mutual fund?
With direct indexing, while it is not possible to invest directly into an index, investors and/or investment managers are essentially replicating an index by buying the individual stocks within it and mirroring their weight.
This option has historically been expensive and time-consuming, making it less attainable for the average investor than ETFs. Thanks to recent advancements in technology and AI, however, access to direct indexing has increased. Today, investors and managers can use advanced software to quickly and effectively replicate their desired indices within a taxable account.
What are the benefits of direct indexing?
There are two primary reasons why someone might choose direct indexing over purchasing an ETF or mutual fund: customization and tax-saving potential.
Customization:
Rather than purchase a share of an ETF, direct indexing allows you to hold shares of each individual stock. This gives you the flexibility to make adjustments and tailor your holdings as you see fit. You can’t pick and choose which securities you want to invest in when purchasing an ETF, since it lacks the ability for customization.
Here’s why flexibility can be important:
Say for example you want to avoid holding shares of companies that have been particularly harmful to the environment, or have a reputation for unsafe working conditions. Direct indexing would allow you to customize your holdings and only invest in those companies that align with your values.
General tax-saving potential:
With direct indexing, you have the ability to leverage a general tax-saving strategy called tax-loss harvesting. Again, this is generally not an option for ETFs or mutual funds, since you only own interest in the fund — not the underlying securities. Tax-loss harvesting enables investors to sell positions at a loss and use those losses to offset the capital gains earned from other well-performing positions.
Is there a downside?
As with any other investment strategy, it’s important to consider the potential drawbacks of direct investing as well — as it won’t be the most suitable choice for everyone.
Direct indexing will generally incur more costs than purchasing ETFs or mutual funds, simply because there is a more active management component to it. Keep in mind, however, that you may be able to offset some (or all) of those costs with your general tax savings.
You may also need a sizable minimum investment amount before getting started. While the actual amount may differ between managers, expect it to be a couple hundred thousand dollars. Depending on your circumstances, you may need to consolidate various investment accounts or continue growing your current portfolio before moving ahead with this strategy.
Which is right for you?
ETFs, mutual funds, direct indexing… Which one belongs in your portfolio? Only you can make that decision since it ultimately depends on your financial goals, personal values, and desired level of involvement and oversight.
The good news is, you don’t have to pick just one. Many investors incorporate multiple products and strategies into their long-term investment plan, meaning you very well may have a place in your portfolio for both ETFs and direct indexing — or some other combination of the three.
Just be sure to do your research first to understand what you’re investing in, what fees are associated with it, and what potential tax liability your investments may incur over time (nobody wants a surprise tax bill!).
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