Portfolio management tool to let investors ‘buy the benchmark’ may come with more caveats than expected
After years of debate between proponents of passive investing and advocates of active management, direct indexing – which allows investors to buy the benchmark and tweak it as they prefer – has promised to be the next big wave for portfolio managers. Asset managers are also taking notice, with big firms either developing their own custom indexing capabilities or acquiring boutiques that have thrived in that niche.
But according to Nicolas Rabener, founder and CEO of FactorResearch, those who buy into the approach may not be getting exactly what they expect.
“Direct indexing marketing materials emphasize that each client receives a fully customized portfolio. … However, this pitch leaves one thing out,” Rabener wrote in a recent commentary published by the CFA Institute. “What is actually being sold is pure active management. A client who eliminates or underweights certain stocks they consider undesirable from the universe of a benchmark index like the S&P 500 is doing exactly what every US large-cap fund manager is doing.”
With the ability to create their own portfolios, he said, clients expose themselves to the pitfalls of active management. That includes the probability of lagging their benchmarks over the short and long term, which even the majority of professional money managers is guilty of regardless of the geography, sector, or asset class they play in.
And while direct indexing does tend to come with lower fees than equity mutual funds, Rabener argued that investing based on personal choice is unlikely to lead to better outcomes than already poorly performing fund managers can produce.
Another benefit touted by believers in direct indexing is how it lends itself well to tax-loss harvesting strategies. But aside from the tendency of tax benefits reaped to be lower in practice than in theory – some argue that the liability isn’t reduced, but only deferred – Rabener contended that managing an investment portfolio around tax optimization carries significant risks, such as selling at the wrong time.
“Typically, the worst-performing stocks rally the most during recoveries. So, if these have been sold off, the investor captures the full downside but only a portion of the upside,” he said. “Furthermore, replacing losers with other positions changes the portfolio’s risk profile and factor exposure.”
Tax-loss harvesting strategies, he added, create yet another layer of active management, which raises the already-high risk of loss from investments. Citing research from Hendrik Bessembinder, he said that just 4% of all stocks accounted for nearly all the excess returns above short-term U.S. Treasury bonds since 1926.
“Most stock market returns come down to a handful of companies, like the FAANG stocks in recent years,” Rabener said. “Not having exposure to any of these in order to, say, maximize tax benefits, is just too risky a choice for most investors.”
