What is direct indexing? Should you build your own index?

Here’s a definition from Morgan Stanley: “Direct indexing seeks to replicate an existing stock index, such as the S&P 500 or the Russell 3000, in a taxable account … Using optimization software, the manager typically includes a sample of the index constituents, which allows for close mirroring of the index’s performance.”

An article by Morningstar Canada suggests direct indexing is “effectively… the updated version of separately managed accounts (SMA). A generation ago, SMAs were that era’s hot commodity: “As with direct indexing, SMAs were modified versions of mutual funds, except the funds were active rather than passive with SMAs.” However, it added, separately managed accounts disappointed, in part because in the early 2000s they charged an average of 2.05% a year. It also said that for do-it-yourself investors, “direct indexing is much cheaper than the early SMAs. Direct indexing through financial advisors is of course pricier because of the second layer of fees, but total annual expenses will still be well below 2%.”

Why would an investor want to do direct indexing? 

It may or may not cut fees but allows for more customization than a straight index fund or ETF would provide and in taxable portfolios could help with annual tax harvesting. 

In the past, buying all the stocks needed to replicate an index, especially large ones like the S&P 500, required hundreds of transactions. Building an index, one stock at a time, is very time-consuming and can be expensive if you’re paying full-pop on commissions. 

However, the advent of zero-commission stock trading gets around this constraint, democratizing what was once the preserve of wealthy investors. Since direct indexing requires knowing exactly how many shares of each index component to buy and periodically reweight, Investopedia notes that “several financial companies now offer automated direct indexing services for individual investors.”

Is direct indexing worth it? How does it work?

When I first read about direct indexing—there have been a flurry of articles in recent months, some of which are cited below—I thought this was some version of the common practice by do-it-yourself investors who “skim” and purchase the major holdings of indexes or exchange-traded funds (ETFs). This thereby avoids any management fees associated with the ETFs. It is—and it isn’t. And we explore this below. 

Direct indexing is another way money managers or financial advisors can “add value” and make money from investor-clients. According to this article that ran in the summer at Charles River (a State Street company), direct indexing has taken off in the U.S.: 

“While direct index portfolios have been available for over 20 years, continued advancement of technology and structural industry changes have eliminated barriers to adoption, reduced cost, and created an environment conducive for the broader adoption of these types of strategies.”

Can you build your own index in Canada?

All these forces also means direct indexing can be attractive in Canada as well, according to the CR report linked above. Because of rising investor demand for customizable personalized portfolios, Cerulli Associates Inc. expects direct indexing assets to rise from USD$462 billion today to USD$825 billion by 2026. That is faster than mutual funds, ETFs or separately managed accounts.

However, an October 2022 article in Investment Executive suggests “not everyone thinks it will take root in Canada.” It casts direct indexing as an alternative to owning ETFs or mutual funds, noting that Boston-based Fidelity Investments Inc. introduced a line of DI products for investors with as little as USD$5,000 to invest. Other players include BlackRock Inc., Vanguard Group Inc., Charles Schwab and finance giants Goldman Sachs Inc. and Morgan Stanley. 

But fees in the 0.25%-to-0.40% range are higher than the 0.10 to 0.15% of many broad-based index ETFs in Canada. So far, IE said, Canadian wealth firms haven’t introduced direct indexing products. It quoted Highview Asset Management Ltd.’s Dan Hallett as saying: “I don’t think there has been any real [client] demand for it.” 

Norm Rothery, publisher of The Stingy Investor newsletter, says the trend seems more advanced in the U.S.: “I don’t know how popular the idea is with regular investors as opposed to being seen as a hot idea for financial firms. It might be one of those ideas that’s a few years ahead of itself.” 

Even so, O’Shaughnessy Asset Management LLC was early in Canada with its DI products, and in 2021 was acquired by Franklin Templeton largely for its “Canvas” custom-indexing platform. 

Rothery adds: “the idea being to allow advisors to brew up their own portfolios for clients using quant/other metrics and pick up the benefits of direct investing like tax loss harvesting.  It’s an interesting way for advisors to add some value.” 

Roger Paradiso, executive chairman of Franklin Templeton’s O’Shaughnessy Asset Management, said: “Advisors are drawn to bending client portfolios to their specific needs, whether it is taxes, values based and/or concentrated stock positions. We believe that trend is only going to grow.”

Wealth manager Matthew Ardrey, a vice president with Toronto-based TriDelta Financial, is skeptical about the benefits of direct indexing for most retail investors. He tells me: “While I always think it is good for an investor to be able to lower fees and increase flexibility in their portfolio management, I question just who this strategy is right for.” First, Ardrey addresses the fees issue: “Using the S&P 500 as an example, an investor must track and trade 500 stocks to replicate this index. Though they could tax-loss-sell and otherwise tilt their allocation as they see fit, the cost of managing 500 stocks is very high: not necessarily in dollars, but in time.” It would be onerous to make 500 trades alone, especially if fractional shares are involved.

Then there’s the problem of how to exit this strategy: “Another 500 trades? Compare that against the cost of IVV iShares Core S&P 500 ETF; its MER is 0.03%. A small price to pay for simplicity I think.”

Finally, Ardrey sees issues for someone attempting this strategy through automatic savings plans. “How are they possibly going to allocate those funds monthly? To me, unless they are paying someone to do this, it does not make much sense … it would likely remove any fee savings they would receive.” Ardrey concludes direct indexing may be more useful for Canadian investors trying to allocate to a particular sector of the market (like Canadian financials), where “a person would have to buy a lot less companies and make the trading worthwhile.”

DI vs DIY

I would call this professional or advisor-mediated direct indexing, and I agree it seems to have severe drawbacks. However, that doesn’t mean savvy investors can’t implement their own custom approach to incorporate some of these ideas. 

Classic direct indexing seems similar but slightly different than a hybrid strategy many DIY Canadian financial bloggers have been using in recent years. They may target a particular stock index—like the S&P 500 or TSX—and buy some or most of the underlying stocks in similar proportions. Again, the rise of zero-commission investing and fractional share ownership has made this practical for ordinary retail investors.

Why would you want to do this? If you’re an investor with significant taxable (non-registered) investments, then the ability to customize your stock ownership may be a way of maximizing tax-loss harvesting. That is, you can pick and choose stocks to sell at year-end to trigger capital losses and reduce current year capital gains, or alternatively to carry back and offset capital gains from the previous three years. It’s also a way you can do your own version of ethical investing; declining to buy, for example, tobacco stocks or defense stocks or any other specialized type of stock that offends your sensibilities. Conversely, it’s a way to double-down on high-conviction stocks such as perhaps the tech giants or energy stocks.

With the S&P 500, you would endeavour to have the 11 major economic sectors represented and in similar proportions. But you wouldn’t have to slavishly imitate the index: after all, if that’s what you want, you can more easily just buy an index fund or ETF.

The Morningstar article linked above suggests DI ’s so-called ability to customize portfolios is mostly “spin.” It then implies that a version of the hybrid DIY approach to DI I believe many financial bloggers already espouse. “But there’s no point in doing so through direct indexing,” it argues, “Instead, buy an index fund to anchor the portfolio, then trade individual equities on the side. Using two investment buckets rather than one is both cheaper and cleaner.”

Indeed, many Canadian ETF enthusiasts, who also like to buy individual dividend-paying stocks, have been doing a DIY version of direct indexing all along. I’m thinking of blogger Mark Seed of My Own Advisor, who advocates a hybrid strategy that does just that. Former advisor Dale Roberts, who runs his own Cut The Crap Investing blog as well as writing for MoneySense and Seeking Alpha, often describes how he “skims” particular indexes to create concentrated high-conviction portfolios. 

As an example, in a recent blog, Roberts wrote: In early 2015, I skimmed 15 of the largest-cap dividend achievers. What does skim mean? After extensive research into the portfolio ‘idea’ I simply bought 15 of the largest-cap dividend achievers.”

The 15 dividend achievers are:

The bottom line: Is it an “ETF killer?”

In practice, I do what Roberts does myself. I own about two-thirds of Roberts’ 15 skimmed picks. This is another version of core and explore, wherein 90% of a portfolio may be core index funds, while exploring with the other 10% on more high-conviction stocks, concentrating on dividend yielders like Canadian banks, or utilities or telecoms. 

This diluted form of direct indexing is also a way to lower fees. For example, I have long owned BMO’s ZEO ETF, which simply holds 10 equally weighted Canadian oil and gas stocks, each representing 10% of the portfolio. As the years went by, I gradually started to “skim” each of those holdings by holding each stock directly, thereby foregoing ZEO’s 0.61% management expense ratio. 

While its enthusiasts describe direct indexing as a sort of ETF killer, it seems to me that hybrid strategies like this will let ETF buyers and individual-stock pickers co-exist, giving them the best of both worlds. 

Jonathan Chevreau is the Investing Editor at Large for MoneySense. He is also founder of the Financial Independence Hub, author of Findependence Day and co-author of Victory Lap Retirement. He can be reached at [email protected].

Read more Retired Money:

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• Tontines in Canada: Moving from theory to practice as a solution to our retirement crisis

About Jonathan Chevreau

As MoneySense’s Investing-Editor-at-Large, he is also author of Findependence Day and co-author of Victory Lap Retirement. Reach him at [email protected], where he is the founder of Financial Independence Hub.

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