Investing in the S&P 500 index is appealing to many people just starting out. It has a track record of strong long-term returns, offers instant diversification and a low barrier to entry: You just set up a brokerage account, pick an index fund or ETF that tracks an index, and let compounding returns do their magic.
But what if there are companies in the S&P 500 that you don’t want to invest in, either for ethical reasons or because you’re already invested in that company elsewhere? A technique known as direct indexing does one thing for you, and it has some additional benefits.
Investors choose direct indexing for three reasons.
Avoiding overexposure
Direct indexing An investment strategy that allows you to buy individual stocks instead of investing in an index fund or ETF. Because it gives you the freedom to customize an index, it can help you avoid overexposing yourself to a single stock.
Mark McCarron, partner and chief investment officer at Wescott Financial Advisory Group, cites the example of a senior executive who already owns company stock and doesn’t want to hold more of it through an index like the S&P 500. “They can invest directly in the index and delist the company and replace it with something that’s more consistent,” he says, noting that’s not the case.
Avoiding companies for moral or religious reasons
Another reason you might choose direct indexing is to exclude companies you don’t align with. The S&P 500 is a fairly large collection of companies, which is great for diversification — but a larger index means it’s more likely to include companies that don’t match your values.
If you want to avoid certain sectors because of religious or moral beliefs, “you can better customize the portfolio using direct indexing to match what you want,” says Chris Kellinghouse, senior vice president and chief investment officer at MCF Advisors.
Tax benefits
One of the most popular reasons people choose direct indexing is to take advantage of a strategy known as leverage. Deduction of tax loss. McCarron says this happens when investors strategically sell certain stocks for tax advantages, which are difficult to pull off with a traditional index fund.
Is Direct Indexing Right for You?
So yes, direct indexing is a way to invest in the S&P 500 and avoid certain companies, but there’s a catch: Direct indexing isn’t easy. Trying to replicate an index like the S&P 500 on your own requires constant, time-consuming research and rebalancing — a commitment that not everyone can afford or sustain.
More online brokers are beginning to offer direct indexing portfolios, but many require a minimum. For example, Charles Schwab’s Personalized Indexing Portfolio requires a $100,000 minimum balance, as Wealth FrontDirect indexing option of publicThe new direct indexing feature has a slightly lower (but still higher) minimum of $80,000 for direct indexing into the S&P 500.
Some brokers offer a more cost-effective version of direct indexing, eg Loyaltyof $5,000-minimum FidFolios, but experts note that larger portfolios typically see the biggest benefits of direct indexing.
A common way to direct an index is to outsource portfolio management to an investment manager. As with online brokers, minimums tend to be higher—but McCarron says they’re not as expensive as they once were.
“Many, many years ago, it was hundreds of thousands of dollars to get access to that ability. Now it’s maybe $250,000 to open an account, and I’ve seen it drop further down to $100,000 to $50,000,” he says.
Alternatives to consider
If the price tag on direct indexing doesn’t seem great, or perhaps it’s a more complicated process than you’re ready to dive into, there are other investment strategies to consider that will give you diversification while allowing you to exclude certain companies.
If you want to prevent overexposure: If you’re worried about overexposure because you work at a place that has a large presence in the S&P 500, you can explore whether there’s a different index fund you can invest in that doesn’t include your company but offers similar diversification. This Stock exposure tool ETFDB might be a good place to start. Just input the company you want to avoid, and it will show you all the ETFs that hold that stock.
If you want to invest based on your values: Aligning your investments with your values is becoming more accessible through standard brokerage accounts. There are many index funds and ETFs that adhere to environmental, social and governance standards (you might know it as ESG Investing). Many robo-advisors also offer predefined ethical portfolio options to choose from. If you want to put your money into companies you believe in rather than avoiding companies you don’t like in a broad index fund, this can be a good influence.
If you want tax reform: While direct indexing can be a good option for tax optimization, many robo-advisors offer tax loss harvesting services in their accounts, often at no additional cost.
