Demystifying Direct Indexing
Understanding Direct Indexing – personalised portfolios for every investor
Just like the rise of streaming services that allow you to personalise your playlist or insurance policies tailored to how you drive your vehicle, technology is enabling a new wave of investment customisation for every individual. For investors, it is Direct Indexing that delivers the benefits of customisation by means of an institutional-grade portfolio designed and managed, just for them.
Direct Indexing is very a well-established market in the United States, growing faster than the booming Exchange-Traded Fund (ETF) sector [1]. Here in Australia, the strategy has only recently become accessible to investors, prompting questions from curious investors and allocators alike. In this article, we will look at providing some answers to help demystify Direct Indexing.
What is Direct Indexing and how is it different to other types of index investing?
The term ‘Direct Indexing’ describes a type of investment where a technology provider utilises individual securities (commonly, shares) rather than a pooled investment structure (like an ETF or managed fund) to track a widely recognised index. Consequently, the technology provider can construct a portfolio for their client with ultimate flexibility. Whether an investor is looking to track an index like the ASX200 for Australian equities or the S&P500 for US equities, Direct Indexing is the best tool for the job. Moreover, because Direct Indexing is an approach that builds portfolios from the ground up, investors can seamlessly incorporate their unique requirements into the portfolio right from the start.
This distinction between Direct Indexing and pooled / unitised structures is crucial. By owning the underlying shares in individual companies and not units in a trust (as is the case for a managed fund or ETF), this effectively creates a personalised version of the index that is tailored to better fit an investor’s specific circumstances, goals and objectives. Other advantages include:
Always retaining full transparency of every security in the portfolio on demand.
Voting rights on each security, so the investor can have their say in the future of the company.
Full flexibility in customising the portfolio to meet personal preferences, constraints, values and accommodating other existing exposures, whilst still tracking their chosen index.
Potential to optimise the portfolio for better after-tax outcomes by minimising turnover and taking a flexible approach to managing capital gains.
Does a Direct Indexing portfolio include every company that makes up the index?
Typically, it does not.
The investment objective of a Direct Indexing portfolio is to deliver a return profile that tracks the target index, while incorporating the unique requirements of the investor. While holding a portfolio of shares with weightings like those of the target index is common among index replication products, this is not necessarily the most efficient way of delivering the same, composite return as the index. Moreover, when an investor excludes stocks from a chosen index, it becomes necessary to deviate from the underlying index weightings to replace the contribution of those excluded stocks. This is no trivial undertaking.
Nevertheless, with the advent of sophisticated portfolio construction technology, Briefcase Direct Indexing algorithms select an optimised basket of shares, rather than simply holding every security in the index itself. In the case of Briefcase Direct Indexing, the actual number of distinct stocks that make up a portfolio will vary depending on range of factors (not least investor personalisation requirements), but a typical Australian equity Direct Index portfolio tends to hold between 25 and 50 securities.
I would like to take advantage of the ability to customise the portfolio with Briefcase, but will this mean I am no longer able to track index returns?
Not necessarily. It’s important to remember that an index is not in itself investible. No investor can buy the S&P/ASX200 index, they invest in an ETF or mutual fund that tracks that index.
When applying customisations via Direct Indexing, the effect on index tracking is modest, much like many investors already experience with an off the shelf ETF which does not allow customisation.
How is a Direct Index portfolio managed?
As index benchmarks are constantly evolving (inclusions, deletions, corporate actions and rebalancing) a professionally managed Direct Index portfolio must be measured and monitored daily to ensure it remains consistent with the investment objective. This involves thoroughly researched considerations such as minimising portfolio turnover, retaining the investors preferences and constraints, as well being tax aware where appropriate.
Every day, each Briefcase portfolio is monitored and modelled to ensure it remains benchmark aware. This daily process ensures that every individual portfolio is not only an excellent representation of the index at all times, but also that transaction costs and other direct and indirect costs are taken into account before rebalance trades are issued.
Is a customised Direct Index portfolio expensive?
A quality Direct Index provider puts to work a combination of investment management expertise and highly technical competency to design and manage a unique portfolio for every investor. This was once an expensive exercise, only in reach of large institutional investors. Thanks to ongoing improvements in quantitative investing and innovations in technology, these costs have fallen substantially – making Direct Indexing available to many more investors.
Direct indexing portfolios can now be accessed for much less than a typical actively managed fund. With trading costs continuing to fall, the opportunity for investors to access their own personalised portfolio has never been greater.
How can I build my own Direct Index portfolios for my clients?
Thanks to our innovative technology platform, Briefcase’s portfolio construction expertise can be utilised by financial advisors to design, implement, monitor and rebalance personalised Direct Index portfolios for their clients. It’s a transparent and low-cost approach to investing, yet a powerful one that combines index investing with customisation to deliver truly personalised portfolio for every investor.
Like to know more? Contact us at enquiries@briefcase.au
References:
1. “The Case for Direct Indexing,” Cerulli & Associates, December 2022.