Direct Indexing is a way to replicate an ETF, by buying the required shares directly.
TLDR;
I believe more people should do direct indexing, vs just buying ETFs. By doing this, investors will reduce costs, and increase control over their investments. One major benefit is owning the voting rights for your shares. I believe with the advent of low-cost brokers and technology, it's now possible for anyone to do this.
What is an Index?
At the core, it's a collection of assets and associated weights. Each index provider gives more specific details on their methodology for how they calculate the weights, and how they construct the index. e.g. MSCI Index Methodology. All the information you need to know about the index is published by the provider.
Well known examples of indices and index providers:
- S&P500 - Index provider: S&P Global
- MSCI World - Index provider: MSCI
- MSCI Europe Financials Index
- Russell 3000 - Index provider: FTSE Russell
These are theoretical constructs, and not tradable assets in itself.
ETFs (Exchange Traded Funds)
What Is an Exchange-Traded Fund (ETF)?
An ETF is an investment fund that holds multiple underlying assets and can be bought and sold on an exchange, much like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of stocks.
Here's an ETF based on the MSCI Europe Financials Index we looked at earlier, iShares MSCI EU Financials. The iShares-Series of ETFs are issued by BlackRock
ETF Populatity and Growth
Global ETF assets under management ("AuM") achieved a remarkable Compound Annual Growth Rate ("CAGR") of 18.9% in the past five years, and has grown by more than 25% from December 2022 to reach a new record of almost $11.5 trillion at the end of 2023. - PWC
These stats are not hard to believe. I'll bet you already own ETF shares? And the most popular "finfluencer" advice you hear on YouTube, LinkedIn, Reddit and TikTok is "Just put your money into ETFs".
When I mention the term "ETF", I'm referring to the popular passive Index-ETFs, but in theory the "ETF" structure can be used to wrap any kind of strategy.
Even for institutional investors (like pension fund managers), ETFs are becoming an investment of choice. Further bolstering the assets under management (AuM) of the ETF issuers.
ETF Risks
But what happens if all investors ignores their obligation to care about their underlying investments and just buys passive ETFs? A handful of ETF issuers, will own all the assets in the index, including the voting power that comes with it.
This is happening right now, I will call this "Voting Rights Concentration Risk" (maybe "shareholder oligarchy" is better?). And you can already see some conspiracy theories forming around this topic. YouTube: BlackRock
The ETF prospectus will disclose all the ETF details and risks to the investor. Both "Direct Indexing" and "ETF" investment approaches share most of these risks. But there are some risks specific to ETFs like:
- Management Risk - No guarantee that the ETF will replicate the index
- Issuer Risk (Credit rating risk) - might adversly affect the valuation of the ETF
Other topics passive ETF investors should be aware of are:
- Securities Lending The ETF manager lends out your securities to enhance yield, this comes at a risk. It's important to understand that short selling will not be possible without securities lending.
- Representative sampling The ETF manager invests into a representative sample of securities that collectively has an investment profile similar to that of an applicable underlying index. i.e. they do not need to hold exposures to all the exact index constituents. As long as their holdings are statistically representitave of the underlying index.
Advantages
- Easy to get started, buy and forget.
- Simple fee structure, one-time commission + annual management fee.
- Note: Operational expenses, like trading commissions, are included into the Fund performance.
- Lower initial investment requirements.
- Simple to keep track of performance.
Disadvantages
- You do not own the underlying assets.
- Giving away your voting rights for free.
- Market risk - ETF share price can deviate (trade at premium or discount) to Fund NAV due to various market factors.
- Extra fees (typical "Expense ratio" of 0.5% per year), this exludes any other expenses and fees that need to be paid by the Fund, which will reduce fund performance. E.g. Portfolio Turnover causes commissions to be paid to brokers. These expenses get rolled into the ETF share price.
Rebalancing
To go from theory ("the index") to practice ("a portfolio") we need to buy and sell shares according to the target weights, as published by the index provider. This is what the ETF issuer does with your money. These target weights get updated regularly by the index provider.
Rebalancing is the act of buying and selling shares periodically within your portfolio to maintain the target weight as published by the index provider (e.g. annually or quarterly). The frequency of rebalancing depends on the index issuer, but ultimately it's executed by the ETF issuer fund as needed. The ETF marketing materials will give more exact details. More frequent rebalancing, increases portfolio turnover, resulting in more fees.
This isn't a complicated process. Here's an example of how you rebalance your portfolio: Below I have a 100k EUR portfolio, tracking a custom EU TOP10 Financials Index.
- I have my current portfolio weights, and the target weights.
- Using this, I calculate the amount of shares I need to buy and sell to get to the target weights.
- In this example, the rebalancing resulted in 4 sells and 4 buys.
There will always be a slight difference between the index and the portfolio performance, this is called "tracking error". This will be present in both ETFs and direct indexing approaches to replicate the index.
Direct Indexing
Instead of going through a middleman, you do it yourself (or through your Financial Advisor). You buy the initial shares, and you rebalance your portfolio periodically.
With the rise of low-cost brokers and technology, Direct Indexing is possible for anyone.
Advantages
- You own each share directly (your name is on the share register).
- Voting rights.
- No management fees.
- Efficient tax loss harvesting possibilities.
- Possible to automate rebalancing.
Disadvantages
- You are in full control, for better or worse, that means you decide when to take trading actions. This can be automated.
- You can follow similar rebalancing schedules as the ETF issuers, monthly / quarterly.
- Minimum investment requirements, because you're not pooling your money with other investors, the barrier to entry is higher.
Voting
This is a topic I'd like more investors to be aware of. I believe the investor has the right to vote, since their money bought the (underlying) shares. This is important for efficient markets.
If all investors become fully passive (lazy), we risk concentrating too much power in the hands of a few large decision makers. This is exactly why we see conspiracy theories about the world being run by a few large Index Fund managers. Because if trends continue, they end up with massive voting power on the boards of the big companies in the world.
Conclusion
I believe if you're an investor you have the obligation to vote, or atleast actively give your vote to a proxy that aligns with your values.
I dont believe an ETF issuer (Index Fund manager) can align with the personal values of all their investors, across all the companies within an ETF. And centralizing these voting rights at the current rate cant be healthy for the financial markets.
A potential solution to the current voting power concentration problem is if Index Funds implement "Pass Through voting".
I hope more investors consider direct indexing options in the future, so that we can head back towards a "Shareholder Democracy".
Disclaimer
This is not financial advice. This is just my thoughts. Do your own research.