ELI5: What is Direct Indexing?

The way we invest is ever-evolving. First it was private shares, then we had public stocks, followed by mutual funds and ETFs. Taking it to the next level, we're now seeing the growth of direct indexing.

Direct indexing is exactly what it sounds like, it's buying an index, directly. Traditional index investing is done using funds. SPY for example allows you to own the entire S&P 500.

The fund structure is popular because of its convenience and low fees. You can own hundreds to thousands of stocks, all neatly wrapped up in a single holding, managed for a few basis points.

With direct indexing, you skip the ETF wrapper and own the stocks directly. So instead of buying SPY, you buy all 505 individual stocks. Yes, there're more than 500 stocks in the S&P 500.

If this sounds super complicated and expensive, it is. To track an index, you'll need to constantly buy and sell shares while paying hefty commissions along the way. Also, unless you're Jeff Bezos, you're unlikely to have enough money to purchase all the shares needed to complete your index puzzle.

Today, these barriers are quickly fading. Free commissions are becoming the norm, rebalancing software is more available and buying fractional shares is now possible.

Despite the changing landscape, indexing with ETFs still seem so much simpler, and it is. So why do people want to go direct?

Customization. Some investors want specific exclusions. This could be for practical reasons. If you're Tim Cook you probably don't need more Apple stock. It could for moral reasons, maybe you want the S&P 500 sans any factory farming stocks. Whatever your preference, going direct enables a portfolio custom fit to you.

Tax efficiency is also a big advantage. When you hold hundreds of individual stocks, there are more opportunities to tax loss harvest compared to holding a single fund.

But beware, customization is a double-edge sword. Deviation from the index creates tracking error and risks underperformance. It pushes you further away from passive towards active. That usually doesn't end well.

While cool, don't get caught up in the hype. Unless you have a specific reason to go direct, good ol' fashion ETFs will do the job.

Comments

Today's Special: Humble Pie

You champion a project, fight for an idea, and then...reality sets in. That churning in your stomach isn't butterflies, it's the realization you've missed the mark. Pride will puff up your chest, and kick in the "defend at all costs" instinct. But arguing with the umpire never changed a call. Admitting you're wrong isn't a sign of weakness. It can strengthen your professional standing. In a world obsessed with the illusion of infallibility, the courage to adjust course is a breath of fresh air. It shows you're confident enough to be wrong, and adaptable enough to learn from it. Do your research, think critically, and stand behind your decisions. But when the data whispers (or screams) otherwise, don't be afraid to swallow that slice of humble pie. Be the first to acknowledge. Don't wait for someone to point out your mistake. Be open, take responsibility, and most importantly, focus on what you're going to do to address it. Don't dwell ...

The Art of Giving Feedback

Constructive feedback is an awkward affair. You don't want hurt feelings, but recognize the importance of honesty. You've tried the classic "hoping things will get better on its own" and unfortunately it hasn't played out. When giving feedback, here are a few things that I try to keep it mind. Start with empathy. Step into their shoes and understand their story. If you don't know, ask. Be genuinely curious. Feedback is a dynamic affair. Shared communication with a shared goal towards progress. Take the emotion out of it. Focus on the situation, not the person. Focusing on the person adds unnecessary weight to an already emotionally-bloated event. Be specific. Give clear examples. Vague feedback equals dismissed feedback. Doing above won't de-awkward things fully, but it will dampen it and increase the chance of better outcomes.

Negative Feedback, Positive Lessons

In the battle against plastic bags, a five-cent tax was shown to be much more successful at deterring usage than a five-cent credit for bringing your own bags. Carrots satisfy but sticks sting, and they sting hard. So we default to the less painful choice of avoiding loss. Loss aversion impacts the way we process information. A 2019 study invited participants to learn through a series of multiple choice questions. Each question only had two options to choose from. Whether guessing correctly or not, they would still learn the right answer. Despite the identical learning opportunity, participants were much more successful at recalling the answers they guessed correctly than those they got wrong. "You're right!" feels good. We savour the moment, analyzing every detail. "You're wrong!" stings. We want to quickly forget, dismiss, and move on. When we succumb to loss aversion, we miss opportunities to learn. Failure is part of the process. We'll experie...

Herman Ye

Search