Direct indexing vs. ETFs

Selecting the best investment option for clients is one of the most important tasks for financial advisors. With a variety of investment possibilities available, it’s essential to understand the benefits of each. 

Direct indexing and exchange-traded funds (ETFs) offer distinct advantages. Understanding the differences between them can help advisors select the ideal approach based on a client’s unique needs.

Direct indexing: The power of customization in investment portfolios

Direct indexing allows investors to own the individual stocks that make up an index, rather than investing in a fund that tracks the index. This provides greater flexibility and control over portfolios. 

Key benefits include:

• Personalization: More customization than traditional funds or ETFs, allowing for tailored portfolios that align with individual values.
• Tax optimization: The ability to implement tax-saving strategies, including tax-loss harvesting and tax deferral.
• Increased control: Investors have greater control over the individual securities in their portfolio, allowing for more direct management.

Exchange-traded funds (ETFs): A low-cost investment option

ETFs are among the most popular investment vehicles due to their simplicity, cost-effectiveness, and ease of trading. 

Key benefits include:

• Diversification: Many index ETFs provide broad exposure to multiple asset classes without the complexity of managing individual securities.
• Cost-effectiveness: Typically low-cost, with minimal fees and management expenses.
• Tax efficiency: ETFs offer tax-efficient structures, making them a great option for tax-conscious investors.

How to choose the right investment strategy for your clients

When selecting the appropriate investment strategy for your clients, there are a few key factors to consider:

Tax efficiency: Direct indexing can offer enhanced tax advantages, including tax-loss harvesting, which can be a significant benefit for high-net-worth clients. ETFs are tax-efficient but do not offer the same level of flexibility in managing taxes.

Customization: Clients interested in ESG or avoiding certain industries may find direct indexing better suited to their needs. The strategy offers the flexibility to tailor portfolios based on specific preferences, unlike ETFs.

Cost-effectiveness: ETFs are typically the most cost-effective investment option, with low fees and minimal management. However, direct indexing offers additional benefits, such as tax optimization and customized portfolio management, which may justify higher costs for clients seeking more control.

Control: Clients who desire greater transparency and decision-making power may prefer direct indexing. On the other hand, some clients prefer the simplicity and cost-efficiency of ETFs.

By understanding the key differences and advantages of each option, you can offer clients more personalized and effective investment solutions.

This is not an exhaustive list of all the similarities or differences between direct indexing and ETFs.

The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional.

Information in the U.S. is provided by SEI Investments Management Corporation (SIMC), a wholly owned subsidiary of SEI Investments Company (SEI).

Investing involves risk, including potential loss of principal. There is no assurance the goals of the strategy discussed will be met nor that risk can be managed successfully. Tracking error risk is the risk that the performance of a portfolio designed to track an index may vary substantially from the performance of the benchmark index it tracks as a result of cash flows, portfolio expenses, imperfect correlation between the portfolio's and benchmark's investments and other factors. This risk is magnified when sampling a benchmark index as the strategy may not track the return of its benchmark index as well as it would have if the strategy purchased all of the securities in its benchmark index. ESG portfolios may underperform other similar portfolios that do not consider conscious company/ESG guidelines when making investment decisions.

Tax and Tax Management Techniques Disclosures - SIMC does not represent in any manner that the tax consequences described as part of its tax-management techniques and strategies will be achieved or that any of SIMC's tax-management techniques, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-management techniques, including those intended to harvest tax losses, and other strategies that SIMC may pursue are complex and uncertain and may be challenged by the IRS. Neither SIMC nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax, penalties and/or interest which may be imposed by the IRS or any other taxing authority; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor. Accordingly, Clients should confer with their personal tax advisors regarding the tax consequences of investing with SIMC and engaging in the tax-management techniques described herein (including the described tax loss harvesting strategies) based on their particular circumstances. Clients and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the Client's personal tax returns. SIMC assumes no responsibility for the tax consequences to any Client of any transaction.