• There's a growing trend known as direct indexing, buying the stocks of an index, rather than a mutual or exchange-traded fund, for goals like tax efficiency or values-based investing. 
• However, it's still more costly than passive investing and won't work for all portfolios, financial experts say.

There's a growing trend known as direct indexing, buying the stocks of an index, rather than owning a mutual or exchange-traded fund, for goals like tax efficiency or values-based investing. 

While direct indexing is traditionally used by ultra-high-net-worth investors, companies like Morgan Stanley, BlackRock, JPMorgan Chase, Vanguard, Franklin Templeton and Charles Schwab are betting on broader access.

"I believe there will be more competition and marketing of direct indexing in 2022," said certified financial planner Rene Bruer, co-CEO at Smith Bruer Advisors in Colorado Springs, Colorado.

And it may reach an estimated $1.5 trillion assets under management by 2025, according to a report from Morgan Stanley and Oliver Wyman, up from $350 billion in 2020. 

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"People want a little more control over what they're investing in," said Michael Whitman, a CFP and managing partner at Millennium Planning in Pittsboro, North Carolina. "And when you buy into a mutual fund or ETF, you're at the mercy of the manager."

Here's how it works: Financial advisors buy a representative share of an index's stocks and rebalance over time, typically in a taxable brokerage account.

Direct indexing generally works best for bigger portfolios because it may be costly to own an entire index. However, this barrier may shift as more brokers offer so-called fractional trading, allowing investors to buy partial shares. 

For example, an advisor may purchase 150 to 200 stocks to track the S&P 500, said Ken Nuttall, CFP and chief investment officer at BlackDiamond Wealth in Wilmington, Delaware. 

"The beauty is that not every stock goes up," he said. As some go down, advisors may sell losing stocks to help offset the portfolio's overall gains, a tactic called tax-loss harvesting. Advisors may rebalance monthly, quarterly or more often during volatile periods.

Almost half of actively-managed accounts don't receive any tax treatment, according to a Cerulli report.

However, financial experts say direct indexing may offer so-called tax alpha, providing higher returns through tax-saving techniques. 

Indeed, strategic tax-loss harvesting may boost portfolio returns by roughly one percentage point, research shows, which may be significant over time.

However, as direct indexing is an active strategy, it is more costly than owning passively managed assets, such as index funds and ETFs.

While the average fee for passive funds is 0.13%, as of 2019, according to Morningstar, the cost for direct indexing may be closer to 0.30% to 0.40%, Whitman said. 

Portfolio customization

Direct indexing may also appeal to those looking for portfolio customization, such as value-based investors who want to divest from specific sectors, said Charles Sachs, CFP and chief investment officer at Kaufman Rossin Wealth in Miami. 

"It's a great way to be able to tilt your portfolio to causes that you believe in," he said. 

Portfolio customization may also be handy for someone with many shares of a single stock.

For example, an Apple or Amazon executive may want to diversify by investing in an index without their company holdings. Direct indexing may allow them to cherry-pick their stocks, he said.

While direct indexing may appeal to those seeking more control, experts say it may be too difficult for do-it-yourself investors. 

"It's almost impossible to go to a brokerage account and buy 100 to 150 stocks and know what you're doing," said Whitman.

And it's not always wise to tweak an index, Bruer added. Those considering the strategy need to discuss the pros and cons with a financial advisor.