Direct Indexing and Its Potential Benefits
Hello, and welcome to another edition of Wealth Management Insights. I’m Steve Edwards, Head of Portfolio Construction and Cross-Asset Strategy at Morgan Stanley Wealth Management. I’d like to talk about direct indexing today—what it is, how it works, and what we see as its key advantages.
Generally speaking, tracking the performance of a market index, like the S&P 500, is a common investing strategy. While these indices themselves are not investable, there are various index-tracking mutual funds and ETFs that many investors utilize to get passive exposure to the benchmarks.
But fewer investors may be familiar with an approach called direct indexing, which also aims to replicate an index but could allow for tax advantages and customization. In a nutshell, direct indexing means you're buying the individual stocks that make up a reference index—or, owning them directly, as the name suggests—instead of buying a basket of stocks.
Managers can implement this strategy through separately managed accounts, a structure that allows for security-level purchases and sales. To start, managers typically run an optimization process to figure out an appropriate sampling of equities to track the chosen index and buy those shares to establish an initial portfolio. Over time, they monitor and update those positions periodically and rebalance in order to achieve investor goals.
But why would an investor consider direct indexing, instead of just buying a mutual fund or an ETF? Let’s talk about two major potential benefits of direct indexing, starting with customization.
On this front, first of all, investors can choose their preferred reference index. Usually, that’s driven by a strategy’s place in an overall asset allocation. For example, investors seeking large-cap US equity exposure could choose the S&P 500 as their index to replicate. Or, if they’re seeking international stocks, they could pick the MSCI EAFE Index as their reference.
Beyond choosing the index, investors can take customization to the sector or security level, based on their personal goals or values. For instance, an investor might wish to avoid companies with high levels of carbon emission, while featuring stocks with more favorable environmental impacts.
The second key benefit of direct indexing is tax efficiency. Arguably, direct indexing’s most quantifiable potential advantage comes through tax-loss harvesting. This involves selling investments at a loss and using those losses to offset realized gains, or potential future gains, ultimately reducing an investor’s tax liability. It’s worth noting that tax-loss harvesting can be especially effective for asset classes that are considered more efficient, such as large-cap growth equities, where it has typically proven to be more difficult for active managers to outperform the index.
Now, while direct indexing does feature some attractive potential benefits, the strategy also faces limitations. For one, it may struggle with buying and selling securities that are less liquid. Also, direct indexing typically requires a minimum investment of $250,000 and may lead to higher management fees than an investment in similar ETF strategies.
Let’s wrap up with a quick overview of some historical and hypothetical simulations we ran, which we used to evaluate the ability of direct indexing to deliver favorable after-tax returns relative to passive ETFs and active strategies. Here’s what we found:
Compared to index-tracking ETFs, direct indexing strategies tended to deliver greater after-tax returns, and they did so with a high probability of success.
And when compared with active strategies, direct indexing tended to do better in more efficient asset classes, over shorter investment horizons, and assuming higher levels of income for taxable investors. This was due to higher tax rates and more favorable tax-loss harvesting opportunities.
We believe that these attributes of direct indexing, when viewed through the appropriate lens, suggest that the strategy may make sense for investors with taxable accounts.
There’s more you can read on this subject, including our recently published report called “Direct Indexing: Opportunities for Customization and Potential Tax Alpha.” For a copy of the full report, or to learn more about employing direct indexing in your portfolio, please reach out to a Morgan Stanley Financial Advisor. Thank you for listening.
Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any
security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures and qualifications at the end of this material.
The Global Investment Committee (GIC) is a group of seasoned investment professionals from Morgan Stanley & Co. LLC, Morgan Stanley Investment Management, and Morgan Stanley Wealth Management who meet regularly to discuss the global economy and markets.
The committee determines the investment outlook that guides our advice to clients. They continually monitor developing economic and market conditions, review tactical outlooks and recommend asset allocation model weightings, as well as produce a suite of strategy, analysis, commentary, portfolio positioning suggestions and other reports and broadcasts.
S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.
For index, indicator and survey definitions referenced in this report please visit the following: https://www.morganstanley.com/wealth-investmentsolutions/wmir-definitions
General: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
Hypothetical performance results have inherent limitations. The performance shown here is simulated performance not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results.
Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs.
Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods.
This analysis does not purport to recommend or implement an investment strategy. Financial forecasts, rates of return, risk, inflation, and other assumptions may be used as the basis for illustrations in this analysis. They should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. No analysis has the ability to accurately predict the future, eliminate risk or guarantee investment results. As investment returns, inflation, taxes, and other economic conditions vary from the assumptions used in this analysis, your actual results will vary (perhaps significantly) from those presented in this analysis. The assumed return rates in this analysis are not reflective of any specific investment and do not include any fees or expenses that may be incurred by investing in specific products. The actual returns of a specific investment may be more or less than the returns used in this analysis. The return assumptions are based on hypothetical rates of return of securities indices, which serve as proxies for the asset classes. Moreover, different forecasts may choose different indices as a proxy for the same asset class, thus influencing the return of the asset class.
Asset Class Risk Considerations
Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. These risks are magnified in countries with emerging markets and frontier markets, since these countries may have relatively unstable governments and less established markets and economies. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations.
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer.
Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.
Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.
Alternative investments may be either traditional alternative investment vehicles, such as hedge funds, fund of hedge funds, private equity, private real estate and managed futures or, non-traditional products such as mutual funds and exchange-traded funds that also seekalternative-like exposure but have significant differences from traditional alternative investments. The risks of traditional alternative investments may include: can be highly illiquid, speculative and not appropriate for all investors, loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than open-end mutual funds, and risks associated with the operations, personnel and processes of the manager. Non-traditional alternative strategy products may employ various investment strategies and techniques for both hedging and more speculative purposes such as short-selling, leverage, derivatives and options, which can increase volatility and the risk of investment loss. These investments are subject to the risks normally associated with debt instruments and also carry substantial additional risks. Investors could lose all or a substantial amount of their investment.
These investments typically have higher fees or expenses than traditional investments.
Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation.
The returns on a portfolio consisting primarily of environmental, social, and governance-aware investments (ESG) may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria.
The companies identified and investment examples are for illustrative purposes only and should not be deemed a recommendation to purchase, hold or sell any securities or investment products. They are intended to demonstrate the approaches taken by managers who focus on ESG criteria in their investment strategy. There can be no guarantee that a client's account will be managed as described herein.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy.
Investors should consult with their tax advisor before implementing such a strategy.
The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.
The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time.
Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States.
This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. The securities/instruments discussed in this material may not be appropriate for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor.
This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We and our third-party data providers make no representation or warranty with respect to the accuracy or completeness of this material. Past performance is no guarantee of future results.
This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material except as otherwise provided in writing by Morgan Stanley and/or as described at www.morganstanley.com/disclosures/dol.
Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.
This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC.
Morgan Stanley Wealth Management is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the “Municipal Advisor Rule”) and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.
Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data.
This material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC.
© 2022 Morgan Stanley Smith Barney LLC. Member SIPC.