ETF VS Direct Indexing

A popular way to invest is to buy an ETF that tracks a particular index; the Standard & Poor's 500 (S&P 500) is one of the most widely followed indexes. It is a stock index that generally consists of the 500 largest US publicly traded companies. John Bogle, AKA Jack Bogle, founder of Vanguard, is known as the father of indexing. He started the first mutual fund that tracked the S&P 500 index in 1976.*  Indexing quickly grew due to its low cost and the fact that the higher expense ratio of actively managed mutual funds did not outperform the index. Today, trillions of dollars are invested in index mutual funds, ETFs, and, more recently, direct indexing, AKA personal indexing. Let's examine the differences between direct indexing versus mutual funds and ETFs.

Advantages of Direct Indexing

More significant opportunity for Tax-loss harvesting (TLH)

Unlike an ETF with direct indexing, you own the individual stocks. This allows the possibility of TLH at the individual stock level instead of the entire basket level. For example, if you own Exxon Mobile (XOM) in an ETF and it is at a loss, but your ETF shares are at a gain, you cannot just sell Exxon Mobile to harvest the loss. By owning the individual shares of Exxon Mobile, you can sell just the individual share or lots of Exxon Mobile at a loss.   

Customization  

Most direct indexing offers the option to customize the index, which is why it is also known as personal indexing. This is an excellent benefit for those who already own a significant position in an individual stock. You can exclude that position from your direct index portfolio, reducing the risk of overexposure. Another customization feature typically offered is the ability to exclude entire sectors.  

Environmental, social, and governance (ESG) preferences

Direct indexing generally offers a greater degree of control over ESG options. Most direct indexing allows you to choose what may be called a tilt or persona that can exclude or include companies with specific criteria in mind—for example, restricting investing in stocks that are harmful to others, such as Controversial Weapons, Riot Control, and Predatory Lending.

Disadvantages

Tracking error

Tracking error is a way to measure how close an ETF of Direct indexing tracks to an index's return. With a greater ability to do tax loss harvesting and customization, you increase the probability of tracking errors.

Cost

ETFs and mutual funds have expense ratios that come out of the performance of the fund. These tend to be very low. Direct indexing does not have an expense ratio but rather what would be known as a separate account management fee. This fee may show up as an expense line item on your statement, or in some cases; the advisor would have the fee changed to them and include it in your advisory fee.   Either way, the cost of direct indexing tends to be more than the expense ratio of an ETF.

Minimum initial investment

The investment minimums to get into most ETFs at a brokerage firm are low, and they can be as low as $50. However, minimums for direct indexing can be well north of $100,000.

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* Investopedia.com

Investment advice offered through Stratos Wealth Advisors, LLC,a registered investment advisor. Stratos Wealth Advisors, LLC andSynergy Wealth Management are separate entities.

Content in this material is intended for general information purposes only and should not be construed as specific investment advice or recommendations for any individual.  Please contact your advisor with any questions or for specific recommendations regarding your own circumstances. Investing involves risks including possible loss of principal. There can be no assurance that a specific strategy will yield a profitable result or protect against losses

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