In an article for Vettafi’s ETFDataBase, James Comtois reviews how direct indexing can solve complex financial problems for clients. The strategy is quite powerful as it blends the best parts of index investing with active management, however it’s only appropriate for a small group of investors.

One is high net-worth investors who are looking to reduce their tax bill. This is because direct indexing can be used to harvest tax losses with regular rebalancing. It also allows investors to capitalize on volatile markets. Frequent rebalancing is estimated to add between 20 and 100 basis points of alpha.

Another benefit is for clients with strong preferences. For instance, some investors may feel strongly about not investing in ‘vice’ stocks, so these stocks can be eliminated, while stocks with similar factors scores can be added. This is because with direct indexing, investors actually own the individual holdings rather than buying an ETF or a mutual fund.

Similarly, direct indexing can allow for diversification that goes beyond the index. For example, someone with a business in the tech industry may want to diversify their investments and holdings away from technology stocks. This level of customization is not possible with traditional index investing. 

Finsum: Direct indexing is quite powerful and growing in popularity. But, it’s only appropriate for a select group of investors with specific needs and goals.