Investing Basics Guide: Direct Indexing and Index Funds

Direct Indexing: Why its gaining traction over index funds among many investors

According to CNBC, index funds have gained market share over many investing vehicles such as actively managed mutual funds and hedge funds over the last few years. Companies like Vanguard and State Street have capitalized on such investment vehicles by heavily marketing the advantages of passive investing. Their argument is simple: Most active fund managers are failing to outperform the broader indexes, such as the S&P 500, and they typically charge higher fees to do so.

First, it is important to understand what an index fund is. It is a type of mutual fund or exchange-traded fund (ETF) that tracks the performance of a particular stock market index, such as the S&P 500 or the Dow Jones Industrial Average. The fund holds a portfolio of stocks that closely mirrors the composition and performance of the index. It is referred to as passive investing because the fund manager is essentially copying the stocks within the index, rather than actively researching, and picking individual stocks. The direct result is an investment vehicle that closely mirrors the performance of the index, with very low management fees.

Direct indexing allows investors to own a portfolio of individual stocks that closely mirror the holdings of an index. For example, if an investor were to use a direct indexing strategy that mirrors the Dow Jones Industrial Average, the investor would directly own the 30 shares of those companies. Direct indexing can be used for a variety of different indexes. By owning the shares directly, investors can customize their strategies to their specific wants or needs. For example, there are direct indexing strategies that seek to maximize tax-loss harvesting to possibly reduce tax liabilities. Customization can also be a key feature for many values-based investors. For example, environmentalists may want to be invested in the market, but would like to avoid oil stocks. Other investors may want to avoid tobacco, alcohol, or arms companies. Direct indexing would allow them to be invested in their respective index while avoiding companies that do not align with their values.

In summary, direct indexing means the investor will directly own the holdings within the index, while index funds allow investors to indirectly own the shares through mutual funds and ETFs. Direct indexing can offer more customization and higher potential returns, but such strategies can often have higher investment minimums than index funds. Such strategies may be gaining more popularity over index funds, but they may be less accessible to smaller investors. Both strategies have their advantages and disadvantages, and it ultimately depends on an individual's investment goals, risk tolerance and investment horizon to decide which one suits them better.

As advisors for Raymond James, we have access to a variety of direct indexing strategies. We can help figure out your financial goals and suitability. If you are looking for direct indexing strategies, we can help figure out which ones are suitable for your situation.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. An investment in these strategies is subject to market risk and an investor may experience loss of principal. Investments that utilize a direct indexing strategy carry specific risks that investors should consider before implementing a direct indexing strategy. In certain market conditions, direct indexing investment strategies may lose value or under perform passive strategies. Direct indexing strategies have the risk of not closely tracking the performance of the underlying index they seek to replicate. While these strategies are designed to track an index, passive investments often do not consider a company’s profitability, financial health, or growth potential in their investment selection criteria.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow” is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Raymond James does not provide tax or legal services.