ELI5: What is Direct Indexing?

The way we invest is ever-evolving. First it was private shares, then we had public stocks, followed by mutual funds and ETFs. Taking it to the next level, we're now seeing the growth of direct indexing.

Direct indexing is exactly what it sounds like, it's buying an index, directly. Traditional index investing is done using funds. SPY for example allows you to own the entire S&P 500.

The fund structure is popular because of its convenience and low fees. You can own hundreds to thousands of stocks, all neatly wrapped up in a single holding, managed for a few basis points.

With direct indexing, you skip the ETF wrapper and own the stocks directly. So instead of buying SPY, you buy all 505 individual stocks. Yes, there're more than 500 stocks in the S&P 500.

If this sounds super complicated and expensive, it is. To track an index, you'll need to constantly buy and sell shares while paying hefty commissions along the way. Also, unless you're Jeff Bezos, you're unlikely to have enough money to purchase all the shares needed to complete your index puzzle.

Today, these barriers are quickly fading. Free commissions are becoming the norm, rebalancing software is more available and buying fractional shares is now possible.

Despite the changing landscape, indexing with ETFs still seem so much simpler, and it is. So why do people want to go direct?

Customization. Some investors want specific exclusions. This could be for practical reasons. If you're Tim Cook you probably don't need more Apple stock. It could for moral reasons, maybe you want the S&P 500 sans any factory farming stocks. Whatever your preference, going direct enables a portfolio custom fit to you.

Tax efficiency is also a big advantage. When you hold hundreds of individual stocks, there are more opportunities to tax loss harvest compared to holding a single fund.

But beware, customization is a double-edge sword. Deviation from the index creates tracking error and risks underperformance. It pushes you further away from passive towards active. That usually doesn't end well.

While cool, don't get caught up in the hype. Unless you have a specific reason to go direct, good ol' fashion ETFs will do the job.

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