The idea of passive index investing is that rather than trying to pick a few companies that you think will do particularly well, you try to invest a little bit into every company in the market. How broadly or narrowly you define “every company” will vary, but the idea remains the same: invest a little into every company so you get market exposure and diversification.
Formal index funds allow investors to invest into all the companies on their stated list (i.e., the index) with little effort through a single ticker. Rather than going out and buying individual positions in 500 companies, incurring transaction fees at each step, you can simply purchase an index of the S&P 500 (e.g., State Street’s S&P 500 ETF labeled SPY).
Index funds are convenient, as simply tracking one stock is much easier than tracking 1,000 stocks. This enables investors to get market exposure with little effort.
When index funds were first created, transaction fees were very high, meaning a pooled vehicle like an index fund could be the only cost-effective way to achieve broad diversification in the market. However, as transaction costs have dropped to near zero, new approaches have become feasible.
Direct indexing is the idea that you do want to own individual positions in 1,000 different companies (compared to buying the index). It’s 2021, we have computers, it’s basically a list, owning 1,000 positions is solvable.
But why would you want to own the positions directly?
One reason is tax-optimization. By owning the positions directly, you can harvest tax losses from any of any of the individual positions. When you own at the aggregate fund level, you can only realize losses if the whole aggregate position goes negative. By frequently trading (with near-zero transaction costs) to capture losses at the position level due to the standard volatility in equity markets, after tax returns can be improved by roughly 0.5-1.5%.
While direct indexing exclusively copies existing published indexes, custom indexing allows the investor to design an index specific to their unique needs. By owning individual positions directly, an investor may add environmental, social, and governance screens to create a custom index more closely aligned to their values. Similarly, they may wish to lean more heavily toward or away from individual traits like stock size or asset class. More broadly, custom indexing allows investors to harvest the benefits of both passive and direct indexing, while customizing their portfolios to more precisely fit their specific needs.