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Sept. 30, 2022, 2:10 p.m. EDT

What is direct indexing?

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By Steve Edwards

Not everyone is built to be their own money manager, which is why many investors choose a more hands-off approach that we in the financial industry call passive investing.

But don’t let the name fool you—taking a passive investing approach doesn’t mean being passive about your financial future. Instead, it refers to a specific strategy where, rather than trying to exceed the market’s performance, you look to match the same returns of a market index like the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.09% .  

Passive investing has become an increasingly popular way to invest because it can be cheaper than paying someone else to manage your investments for you. Many passive investors buy shares in exchange-traded funds (ETFs) and mutual funds that are designed to mirror market benchmarks, simply looking to “go with the flow” of the markets.

While ETF and mutual funds provide an efficient means for passive investing, investors can potentially enhance a passive strategy through direct indexing. Similar to an index-tracking ETF or mutual fund, direct indexing strategies look to deliver the pretax returns of an equity index. Instead of a commingled vehicle, asset managers carry out direct indexing on your behalf by taking positions in a representative sample of underlying index constituents. This approach offers flexibility for customization, including which index to track and exposures to avoid or feature, and possible tax advantages.

In other words, this allows you to choose the actual ingredients and directly own the underlying equities in your basket, rather than buying a pie that someone else baked. But how does direct indexing help, and how can you know if it might be right for you?

A more active passive approach

While direct indexing is still mostly used by high-net-worth individuals, it’s becoming more popular and more accessible to everyone.

You can take part in direct indexing through a direct indexing separately managed account (SMA) manager. Typically, most investors choose an off-the-shelf index such as the S&P 500 index, but the strategies do typically lend themselves to customization—including selecting an existing index or seeking to accentuate or avoid certain exposures. It’s helpful to work with a financial adviser with direct indexing, since this strategy will need to be deployed in advisory programs.

Direct indexing offers some compelling advantages over other forms of passive investing:

  • Tackling taxes. Our research shows that the systematic, year-round tax management provided through direct indexing may add up to 2% in annual after-tax excess returns. Direct indexing can also become a vehicle for tax-loss harvesting, charitable giving flexibility, holding period management, or gain-realization deferral. These tax savings can help soften the impact of market volatility and offset realized capital gains from other investment strategies, including active managers. Make sure to talk with your tax professional about the choices available to you and how direct indexing might play a part.

  • Customizing based on your values. Since direct indexing allows you to customize your investment exposures, it can be especially useful if you care about giving priority to your values. For example, direct indexing can deploy environmental, social, and governance (ESG) and other value-based screens, like gender equality, racial justice, or religious values. And what if you simply do not want to invest in a company for any reason at all? You can factor those out too. 

  • Customizing your strategy. Another lesser-known customization of direct indexing is the ability to utilize less common indexes or design your own custom solution by combining multiple benchmarks to create something entirely your own. If you receive equity compensation from your employer or own a large concentration of a particular company’s stock, direct indexing can also offer a path for you to diversify and balance against that concentration risk.

Keeping your eyes open

Of course, there are two sides to every coin. Passive investing in general—and direct indexing in particular—may not necessarily be the best choice for everyone, and it’s important to think through all your financial goals before getting started.

More specifically, direct indexing may be most prudent for those who have a large amount to invest in a taxable account and desire a high level of customization they can’t get anywhere else.

Owning your financial future is important—so it’s important to connect with trusted tax and financial professionals before you dive into direct indexing (or any strategy for that matter). As more people recognize the opportunities inherent in direct indexing, it may be worth looking into this strategy, and how it can play a part in your own financial journey.

Steve Edwards is Managing Director, Morgan Stanley Wealth Management Global Investment Office.

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