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Introduction to Custom Direct Indexing Thumbnail

Introduction to Custom Direct Indexing

By Simon Tryzna, CFA, Chief Investment Officer

Custom Direct Indexing is a trend in portfolio management that is growing in popularity amongst advisors and portfolio managers alike. Due to commission-free trading and improvements in technology, portfolio managers now have the resources to apply custom index methodology on their client's portfolios to make them more efficient. And while at the moment it's not appropriate for every client's portfolio, there are two immediate applicable instances where this could be an excellent solution.

Before I dive deeper into that, I think it's important to understand what Index Mutual Funds & ETFs seek to accomplish and how Custom Direct Indexing builds off that. For this piece, we will focus solely on equities.

Index Funds, which can be either be an ETF or a Mutual Fund, look to replicate a basket of stocks (known as an Index). For example, SPY (the SPDR® S&P 500 ETF) looks to replicate the S&P 500 Index by owning each of the names in the index at the appropriate weight. For example, AAPL has a weight of 6.16% in the index (as of 9.16.21), so SPY too has a position in AAPL with a weight of 6.16%. Mutual Funds replicating the S&P 500 Index will look about the same. A $2,000,000 portfolio with a 25% exposure to the S&P 500 ($500,000) could simply have one ETF or Mutual Fund to get that necessary exposure instead of owning the 500 names directly.

While an ETF or a Mutual Fund is operationally more efficient than owning the 500 individual names, advances in technology and the introduction of commission-free trading have made custom indexing arguably more efficient for clients with a concentrated equity position and/or significant embedded capital gains.

The simplest way to think about direct indexing is that it is an investor's personal ETF. Rather than allocating the $500,000 referenced above to SPY, the same investor could allocate that to a direct indexing strategy executed via a Separately Managed Account. At ClearPath, that would mean an opening of a new brokerage account at TD Ameritrade. The investor would have full transparency into the account and be able to see it alongside their other TD accounts.

A passive S&P 500 Direct Indexing Strategy would own a set amount of equities in order to replicate as much of the Index performance as possible. Because the S&P 500 is a market-cap weighted index (the ten biggest names make up approximately 28% of the weight), many of the "bottom" 400 stocks have minimal weights and thus are largely irrelevant to portfolio performance. Many of them are also highly correlated to one another. Therefore, the actual Direct Indexing Strategy does not need to own the full 500 names to come close to replicating the performance of the S&P 500. They can do that with just 130-150 stocks.

In other words, an investor now only needs to own as little as 130 names to get a replicate performance of the S&P 500. There will be some tracking error (the difference between the return of the S&P 500 and the direct indexed portfolio), but a good direct indexing manager will look to minimize that as much as possible.

This strategy becomes more appealing once you can customize it to fit the investor's needs. For example, let's take an investor who has realized a significant capital gain in February from the sale of their highly appreciated equity position (think recently IPO'd company, or a private company that just completed a tender offer). A direct indexing strategy can be customized to run as "zero capital gain." Per research from OSAM, "even though the stock market rises in about 71% of calendar years, roughly 36% of individual stocks deliver negative returns annually." A customized direct indexing strategy can harvest losses on an ongoing basis, which could be daily, monthly, or quarterly, depending on the index provider. The benefit to the investor is that they could have exposure to the S&P 500 while actively harvesting losses to offset the realized capital gain of their stock. The magnitude of the realized losses would depend on market performance and how much tracking error the investor is comfortable with. However, it is still an attractive alternative to simply owning the SPY directly. Even in a year where the S&P 500 finishes in positive territory, it is highly likely that the strategy will harvest some form of losses.

The obvious downside to continually selling "losing" positions and keeping the "winning" ones is that eventually, the portfolio will stop being able to replicate the S&P 500 and have significant embedded capital gains of its own. A well-designed direct indexing strategy will seek to pair gains with losses whenever possible to reduce tracking error and the realized capital gains.

Each investor will have their own investment objectives and different tolerance levels for how much capital gains they are comfortable realizing in any given year. This is where the customizability feature comes to play. An investor with $250k in realized gains in one year will be more than comfortable with a high tracking error to realize losses to offset the existing gains. In subsequent tax years, they will be okay with realizing some additional gains that were a byproduct of holding on to "winners" as the portfolio naturally rebalances to the appropriate weights. The beauty of the strategy is that it is incredibly client dependent. The technology being developed allows me, the portfolio manager, to manipulate the index to meet the investor's needs.

The second insight to where this is useful is for investors with existing legacy positions (with large embedded capital gains) in stocks that are considered "mega-cap," like Apple, Microsoft, Facebook, and Amazon. With a customized direct indexing portfolio, we can build a tailored portfolio around a concentrated stock position. For example. Apple is the largest constituent (has the biggest weight) of the S&P 500. An indexing solution could incorporate that into the portfolio and build U.S. equity exposure around the position. An investor with a $100,000 position in AAPL and a $500,000 position in SPY has a $130,800 position in Apple. The combined weight of APPL in that $600,000 portfolio is 21.8%. In addition to the significant overweight, the investor is likely carrying more risk than realized. Several large stocks are highly correlated to AAPL that could bring the overall portfolio down should there be a correction in tech or mega-cap stocks.

A customized direct indexing solution could result in a portfolio built around the AAPL position. That portfolio could have the appropriate weight to technology given the investor's risk level and overall investment portfolio objectives. Over time, the weight of APPL in that $600,000 portfolio could be lowered down to 10%, or even down to its appropriate market weight in a very tax-efficient way.

The latter example is an intriguing solution to exiting out of concentrated equity positions. While I used AAPL to explain how it would work, this process could work with any publicly traded company. Advances in technology have allowed for incredible customizability and to be a powerful solution for investors.

Due to the customizability of direct indexing, perhaps the best way to understand its benefits is to see how it could fit in your investment portfolio & financial plan. Please do not hesitate to email me with any questions about this and if you're interested in seeing if Customized Direct Indexing would make sense for you.