The Difference Between Direct Indexing and ETFs Direct indexing is a relatively simple concept.

Direct indexing, a strategy that provides investors with enhanced opportunities for customization, has been garnering a lot of attention these past few years. It's a relatively simple concept: With direct indexing, the investor seeks to replicate the performance of a given index by buying a representative amount of the underlying shares.

Unlike with exchange-traded or mutual funds, the investor directly owns the component stocks and can therefore tweak the index to better reflect their values, financial preferences and tax situation. This is made possible using custom passive separately managed accounts (SMAs) that offer broad index-like exposure.

Until relatively recently, direct indexing was viewed as the preserve of the ultra-wealthy. This was in large part because of the domain expertise required and the prohibitive costs associated with trading in and out of individual securities. However, rapid technological advances, as well as a seismic shift toward commission-free trading and fractional shares, are now making this strategy more accessible to a broader swath of investors.

Since exchange-traded funds (ETFs) burst onto the scene in the 1990s, financial advisors and investors alike have been drawn to their low cost and tax-efficiency relative to mutual funds. Now, as the investment management industry stares down another potential disruption in the form of direct indexing, it's worth exploring the factors that make this burgeoning trend so appealing.

Here's a brief overview of how direct indexing stacks up against index funds in key areas.

Values alignment

As major news events heighten consumers' awareness of how major companies are easing or exacerbating critical issues, ESG ETFs have seen record inflows. However, as interest in these products has grown, so too have allegations of greenwashing, with various fund managers facing accusations that they have misrepresented the sustainability credentials of their "ESG" products.

Complicating this dynamic further still is a lack of clarity or standardization around ESG nomenclature and data inputs — some funds use such broad and opaque criteria that an investor with reasonably nuanced views is unlikely to see his or her ethical standards met.

Central to direct indexing's appeal is the flexibility it affords investors, enabling them to customize a given index around the factors most important to them, including their environmental, social and governance (ESG) priorities. With direct indexing, investors can articulate their definition of sustainability and create a custom portfolio that reflects their values as opposed to someone else's worldview.

Some investors might choose to eschew entire industries (e.g. oil, tobacco) or business practices that they deem antithetical to their values, whereas others might opt to allocate more capital in support of companies that are making strides to advance certain causes. Many portfolios incorporate both approaches: carefully divesting from select companies that are having the most negative impacts on an issue, while "rewarding" those that are driving positive impacts.

Direct indexing offers socially and environmentally conscious investors the opportunity to elevate their impact further still via shareholder engagement. Because SMA investors enjoy direct ownership of the companies in their portfolios, they can leverage their position to submit shareholder proposals and exercise proxy voting rights. This allows them to have a say on key issues such as a company's treatment of its workforce, board diversity and efforts to reduce greenhouse gas emissions.

Related: The Growth of Sustainable Investing

Flexibility

Direct indexing can be a good fit for investors who want their portfolios to reflect their unique ethical convictions, but its customization capabilities don't end at values integration. Direct indexed portfolios can also be modified to meet an investor's predilection for certain stock characteristics, e.g. value or momentum, employing factor tilts to favor those characteristics. While there are several ETFs on the market that target various factors, sectors and geographies, investors might find that they have to combine a number of funds to create something close to their preferred allocation.

Direct indexing also has the edge when it comes to helping investors with large single-stock positions to manage concentration risk. This can be a particularly compelling feature for executives at publicly traded companies who already hold stock options from their employer and are keen to avoid additional exposure. Whereas an ETF could create overlap and cause an undesirable percentage of the client's assets to be invested in their employer's stock, direct indexing allows for more precise removal. A direct indexed SMA can be carefully constructed to limit exposure to a specific stock or sector, helping to mitigate portfolio risk.

Related: How To Get Started in Passive Real Estate Investing

Tax efficiency

Most people wouldn't instinctively think of investment losses as being a good thing. But in the case of direct indexing, these losses can present investors with opportunities to reduce their tax liabilities — even in an appreciating market.

Because a custom SMA contains individual securities and the investor directly owns each position, ailing investments can be sold to offset taxable capital gains or ordinary income. This strategy, known as tax-loss harvesting, can help to boost the investor's after-tax returns. If there aren't losses to harvest, investors with direct indexing portfolios have the option to defer capital gains on highly appreciated shares — or even donate that stock to their chosen charity and avoid capital gains tax entirely.

ETF investors, on the other hand, may find themselves a little more inhibited. Research has indicated that, even in bull years, most stocks underperform the index of which they are a component. This means that, regardless of whether an ETF's underlying index has increased in value during a given year, there may still be some laggards impeding its broader performance. ETF holders don't have the option to target these losing securities and reduce tax drag; instead, they would have to sell off the entire fund — including stocks that had a stellar year — and replace it with a similar product that tracks a different index (to satisfy the Internal Revenue Service's wash sale rules).

Cost

As any savvy investor knows, fees can have a significant impact on overall portfolio returns, especially when compounded over time. ETF fees are advertised as an expense ratio, which represents the costs associated with operating and managing the fund. This number, expressed as a percentage of the fund's average net assets, denotes how much will be automatically deducted from the fund's assets — and the investor's net return — on an annual basis.

The overwhelming majority of ETFs are passively managed and seek to track an index, meaning that they are not investing heavily in research and analysis. This translates to attractively low operating expenses, which have helped drive massive inflows into ETFs. With this asset growth comes the ability for fund managers to exploit economies of scale and reduce costs further still.

Management fees for direct indexing portfolios vary from provider to provider, but are typically slightly higher than those for ETFs. However, as is probably evident by now, we're not comparing apples to apples here. While a direct indexed SMA may deliver similarly diversified, index-like exposure, it adds a variety of supplemental benefits in terms of flexibility, transparency and control. While these can serve as significant differentiators in a client's eyes, perhaps most notable are the tax capabilities mentioned above. These can help to deliver higher after-tax returns for the investor, potentially meaning more money in their pocket and thus justifying the additional basis points incurred.

The future of direct indexing

ETFs continue to represent a cost-effective, diversified solution that can serve as the building blocks of clients' portfolios or complement existing holdings to provide exposure to different countries, asset classes and investment styles. They're a particularly accessible and appealing option for "smaller," cost-conscious investors that have tax-exempt accounts with limited customization needs.

However, just as ETFs emerged to present a credible threat to mutual funds' dominance, direct indexing's annual growth over the next five years is projected to surpass that of ETFs and mutual funds. We've already witnessed widespread democratization of financial products and the meteoric rise of passively managed strategies this past decade. It's not unreasonable to assume that, as personalization becomes a "must-have" rather than a "nice-to-have" for businesses across all sectors — and as investors look to integrate their values into their financial lives — direct indexing could become more widely available. With that in mind, financial advisors should be ready.

Related: This Is Why You Should Be Investing in Real Estate Right Now