Direct indexing may be the next big thing, as a Barron’s column recently suggested, but it won’t help retirees or near-retirees.
Direct indexing, for those of you who are unaware of it, allows you to imitate an index fund by purchasing each of the component stocks directly in your brokerage account. Before direct indexing, of course, your only alternative was to own the stocks indirectly through an index fund.
Proponents of direct indexing trumpet a number of supposed advantages. It allows you to customize your index according to whatever criteria you might wish to impose, for example. You can manage it to be more tax efficient, furthermore. And with the advent of zero-commission trading and the ability to purchase fractional shares, you can imitate an index such as the S&P 500 SPX, +0.67% with a relatively small portfolio.
Unfortunately, the disadvantages of direct indexing outweigh any advantages, Lawrence Tint argued in an interview. Tint should know, since he devoted much of his investment career to perfecting index funds. He is the former U.S. CEO of BGI, the organization that created iShares (now part of BlackRock).
In fact, Tint argued, the advantages of direct index either don’t exist or don’t apply to retirement accounts. Take the ability to customize your index. That’s just active investing in sheep’s clothing, Tint reminded us. We all know how poor the odds exist for trying to pick a group of stocks that will outperform the overall market. I present below some new evidence on how poor those odds are.
Tint did allow that there is the theoretical possibility that you could manage a direct index with greater tax efficiency than by investing in an index fund. But he mentioned two caveats. First, even if you were able to be more tax efficient in your direct index portfolio (which is by no means assured), the benefit would be small since index funds incur little turnover. Secondly, the portfolios of retirees and near-retirees will almost certainly be in tax-deferred accounts, for which relative tax efficiency is irrelevant.
Direct indexing’s downsides
Balanced against those either nonexistent or minimal advantages, direct indexing has some distinct disadvantages, according to Tint. The first is that, unlike for index funds, your direct indexing portfolio does not earn any securities lending revenue. This is the income that your brokerage firm earns when lending out your shares to short sellers. Because the amount of such revenue depends on the kind of stocks that your fund holds, no two index funds will have the same securities lending income yield. But it can be significant. According to a Morningstar analysis, this yield for the iShares Russell 2000 ETF IWM, -0.42% between 2007 and 2018 averaged 0.19%.
That income is one of the big reasons why index funds are able to charge minimal fees. And while you may think your direct indexing portfolio would still come out ahead on fees, you are kidding yourself. Though most brokerage firms now offer commission-free trading, you still incur the cost of bid-ask spreads when buying or selling. Your brokerage firm may also charge asset-based fees for your direct-indexing account.
Another disadvantage of direct indexing comes when trying to reinvest dividends. To exactly match an index, you would need to reinvest each dividend in each of the component stocks in the index, in just the right proportions so as to preserve each stock’s proper weight in that index. The logistical hurdles are considerable.
The bottom line? It’s easy to understand the fee-based motivations for why brokerage firms are pushing direct indexing. But it’s not as easy to understand how individual investors, and especially retirees and near-retirees with tax-deferred portfolios, are any better off because of it.
The poor odds of active management
There’s a novel way of measuring whether advisers add value through their trading: Calculate whether their portfolios are ahead or behind of where they would have been had they undertaken no trades since the beginning of the year. This approach is so revealing because it doesn’t compare an adviser to an abstract index, but instead to himself without the trading.
I conducted just such an analysis for each of the investment newsletter portfolios that my firm audits, creating a hypothetical portfolio that was an exact copy as of the beginning of this year—and which, since then, has made no changes. If this hypothetical “frozen” portfolio is today worth just as much or more than its corresponding real-world portfolio, then we know its trading didn’t add value.
As was also the case in prior years, this year’s frozen portfolios on average came out ahead. For the first 11 months of this year, in fact, they were 2.1 percentage points ahead.
This result is very telling because the newsletters currently monitored by my auditing firm are those that have the best historical records in my Hulbert Financial Digest tracking service. These results mean that even the very best advisers have difficulty beating the market.
This is yet another reason to be skeptical of direct indexing.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.