Direct indexing is a hot strategy for financial advisors looking to differentiate themselves from potential clients, but what is it and when does it make sense for clients?
The idea behind indexing, of course, isn’t new. Vanguard Group founder John Bogle created the world’s first index mutual fund in 1975 when he launched the Vanguard 500 fund, which did nothing but track the stocks listed in the Standard & Poor’s 500 index. a complex scenario in which fund managers chose individual stocks, the index was simple for investors to understand, provided broad exposure to US equities, and was cheap to run, resulting in lower fees.
In 2021, there were 7,481 mutual funds in the United States, and that total was down from 2020. But despite a plethora of indices that fund managers could track, the funds still aimed to cover a broad mix of stocks. . The custom indexing advantage, also called direct indexing or custom indexing, avoids the one-size-fits-all approach to creating an index designed to meet an individual investor’s goals. Custom indexing can be a great way for investors to settle for a challenging market and will continue to grow in popularity, as O’Shaughnessy predicts that by 2025, most financial advisors will have software to manage custom indexes.
For additional assistance custom indexing into your financial plan, consider working with a financial advisor.
What is Custom Indexing?
A custom index is set up as a separately managed account for an investor who buys individual stocks directly. These selections are based on an existing index, then adjusted and optimized using sophisticated software to meet the needs, circumstances and priorities of the individual account holder. These accounts carry higher fees, of course, and are best suited for high-net-worth individuals with sizeable portfolios who can benefit from a range of customized options, particularly in four scenarios.
Collection of tax losses: Even when a given index is up, some of its individual stocks are trading at a loss. Because the investor in a custom index holds individual stocks, it is possible to sell those stocks that are down, creating a tax loss that can be used to offset taxes owed on the overall index gain. Another advantage is the ability to separate long-term and short-term gains and losses within the index.
ESG investments: Socially conscious investors concerned about the environmental, social and governance policies and standards of the companies that make up their holdings. Unlike investing in a standard index, a custom index can be designed to avoid stocks of companies involved in fossil fuels or weapons, for example to include companies that promote diversity and inclusion or to bypass companies with particular political or a history of illegal behavior.
Investment factor: Investing in companies with specific characteristics — “factors” — such as value, rapid growth, or in highly specialized market segments is difficult to achieve with a standard mutual fund or ETF. With virtually any single stock available, a custom index can be tailored to meet those criteria.
Diversification: Standard indices built around growth, value, or some other factor can end up being overly concentrated in some sectors, such as technology. Additionally, a senior executive may be required to hold a significant number of shares in his or her employer. For example, a healthcare CEO can create a custom index.
Custom indexing involves setting up a separately managed account for an investor buying individual stocks directly. This technique is becoming increasingly popular with financial advisors who have the software to tailor this strategy to meet the needs of the investor.
Tips for investing
Investing, whether in custom indexing or buying individual stocks, can be complex. Sometimes it helps to have an expert at your disposal. SmartAsset’s free tool connects you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
In addition to working with a financial advisor, be sure to use our free investment calculator to give you a quick estimate of how your portfolio will fare over time.
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