Direct Indexing vs ETFs: Key Differences | Index One

In this edition of Index One Insights by Index One , we explore the key differences between direct indexing and ETFs, helping you determine which investment vehicle best aligns with your financial goals.

Also in this edition:

?? POLL: What is your use case for direct indexing?

?? Index Spotlight

?? BX/FolioBeyond Dynamic Volatility Fixed Income Index

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Introduction

According to a previous forecast, assets in direct indexing products are projected to reach US$825 billion, growing at a compound annual growth rate (CAGR) of 12.3% through 2026 (Cerulli Associates).?

According to the latest estimate by Oliver Wyman and Morgan Stanley, direct indexing could reach approximately $1.6 trillion globally by 2025. (Direct Indexing Buyers Guide - WealthAdvisor)

Meanwhile, the global ETFs industry set a record by gathering US$1.88 trillion in 2024 (ETFGI), contributing to the industry's rapid expansion, which is expected to reach US$15 trillion in assets under management (AUM) by 2025 (HedgeFundAlpha).

With the rise of both direct indexing and ETF strategies, it is becoming increasingly important to understand the distinctions between these two investment vehicles. Index One has received a significant number of inquiries about both approaches, with investors frequently asking which is better for their specific needs.

In this article, we aim to clarify the differences between direct indexing and ETFs, providing insights to help you determine the most suitable approach for your investment management objectives.

Key Differences between Direct Indexing and ETFs

1. Ownership & Control

• Direct Indexing:

With direct indexing, you own the individual stocks within the index, providing direct exposure to each security.

Direct indexing offers greater customization, such as excluding specific companies or sectors and applying ESG (Environmental, Social, Governance) filters.

Direct indexing provides full control over your portfolio, including tax-loss harvesting and rebalancing decisions.

• ETFs:

By buying an ETF, you own shares of a fund that tracks an index, giving you indirect exposure to the underlying stocks.

ETFs offer limited customization since ETFs are pre-constructed, offering minimal flexibility in selecting or excluding specific securities.

ETFs automatically rebalances without investor involvement.

2. Cost Considerations

• Direct Indexing:

Direct indexing typically requires a higher initial investment to purchase individual securities.

Direct indexing may involve transaction fees when buying or selling stocks, though fractional shares can improve cost efficiency.

Direct indexing offers tax benefits through tax-loss harvesting, allowing you to offset gains and reduce tax liability.

• ETFs:

ETFs generally feature lower expense ratios and often no transaction fees for buying or selling (depending on the broker).

ETFs do not provide direct tax-loss harvesting since you don’t control individual securities within the fund.

3. Rebalancing

• Direct Indexing:

Rebalancing direct indexing strategies is done manually or automatically through brokerage platforms, allowing investors to adjust based on specific criteria (e.g., market shifts or personal goals).

Direct indexing enables customized rebalancing to align with individual preferences, such as maintaining sector weightings or risk levels.

• ETFs:

Rebalancing an ETF is automatic and follows the methodology of the underlying index, requiring no action from the investor.

The convenience of automated adjustments reduces management effort but limits customization.

(Via America’s Best Direct Indexing Buyer’s Guide)

4. Tax Efficiency

• Direct Indexing:

Direct indexing is highly tax-efficient due to the ability to sell underperforming securities individually for tax-loss harvesting, helping offset realized gains.

Direct indexing provides greater control over when to realize gains or losses, optimizing tax strategies.

• ETFs:

ETFs are generally tax-efficient, but investors lack the ability to conduct tax-loss harvesting on individual securities.

Capital gains distributions may occur when the fund buys or sells securities, potentially creating tax liabilities.

5. Diversification

• Direct Indexing:

Direct indexing offers broad market exposure but requires purchasing all necessary stocks to replicate an index, which can be time-consuming.

Direct indexing allows for personalized diversification, such as adjusting sector or geographic weightings based on personal preferences.

• ETFs:

ETFs provide instant diversification by representing an entire index composed of multiple stocks or assets.

ETFs are a simple and efficient way to achieve diversification with minimal effort.

6. Ease of Use

• Direct Indexing:

Direct indexing requires more active involvement, such as managing the portfolio, backtesting, and rebalancing.

Direct indexing investors need a solid understanding of how indices work or access to third-party platforms or tools to manage custom portfolios effectively.

• ETFs:

ETFs are simple and straightforward for most investors—just purchase ETF shares, and the fund manager handles the rest.

ETFs are ideal for passive investors due to its hands-off nature and minimal time commitment.

7. Minimum Investment

• Direct Indexing:

Direct indexing typically requires a higher investment amount to purchase individual securities, with some platforms imposing minimum account thresholds.

Fractional shares have lowered the barrier, making direct indexing more accessible, though it still has a higher entry cost than ETFs.

• ETFs:

ETFs generally have lower minimum investment requirements, making them more accessible to smaller investors.

Some brokers also offer fractional ETF shares, enabling even greater affordability.

Direct Indexing vs ETFs: Which to Choose?

To summarize, consider the following factors when determining which vehicle best aligns with your clients' personal investment goals.

Choose Direct Indexing If:

• You want greater control over your portfolio and investment decisions.
• You prioritize tax-efficient strategies, such as tax-loss harvesting.
• You require customization, such as ESG filtering, sector exclusions, or tailoring stock selections to your preferences.
• You have the resources and are comfortable managing a more hands-on investment strategy.

Choose ETFs If:

• You prefer a simple, passive investment strategy that offers automatic diversification.
• You have a smaller budget and want to avoid the complexity and costs of purchasing individual stocks.
• You don’t want to spend time on active portfolio management or making detailed investment decisions.
• You value low costs and ease of use, with minimal effort required to maintain your investments.

POLL: What is your use case for direct indexing?

Josh Krugman, product area leader for brokerage at Fidelity states that "customers want investment choices." (Money.com)

Direct indexing provides investors with this customization and choice in several use cases.

What is your use case for direct indexing?

Vote now

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