Index funds are passive investments. They track an index with the goal of replicating the performance of that index, minus expenses. They're a popular investment choice for good reason—they’re often cheap, diversified, and uncomplicated portfolio building blocks.

Active funds, meanwhile, are led by managers who choose particular securities in an effort to outperform an index.

What is an index fund?


When you own shares of an index fund, you own the stocks in the index fund indirectly, in the same proportion as the index.

For example: Let’s say you invested $100,000 in an index fund that tracks the S&P 500.

Because the S&P 500 is tilted toward the largest companies in the market, you have some pretty sizable stakes in some of these big blue chips—nearly $6,000 in Apple (AAPL); over $5,000 in Microsoft (MSFT); $4,000 in Amazon.com (AMZN), and so on.

What does it mean to own stocks indirectly?


Indirect ownership means that even though you are exposed to the companies’ fortunes and failures, you don’t have the benefits of direct ownership.

For instance, even though you may have thousands of dollars committed to these companies, an invitation to the shareholders’ meeting will not be forthcoming. Nor do you have a say in board member elections—the portfolio manager that runs the index fund votes in shareholder elections on your behalf.

You also can’t buy and sell the underlying securities, or trim any of the positions in the index fund for any reason. What if you thought Apple was overvalued and wanted to reduce your position? You’re out of luck as an index fundholder. What if Meta’s (META) data privacy and security issues give you pause, and you want to remove it from your portfolio? As an index fund investor, you are stuck holding the stock as long as it’s in the index.

How does direct indexing work?


Direct indexing means you own the stocks in the index directly. It’s a pretty straightforward idea, but most people don’t do it, and those who do are usually working with an advisor in a separately managed account.

For one thing, some indexes track areas of the market that aren’t as “liquid,” meaning the component securities can be thinly traded and priced inefficiently. Funds that track such indexes often use a sampling or optimisation method to mimic the performance of an index.

But even the S&P 500, which is a relatively compact index comprising very liquid (easily tradable) stocks, isn’t that easy to replicate.

One barrier to doing this, traditionally, is that you can’t buy every stock in the index if you don’t have a lot of money to invest. This is essentially why managed funds were created; they allow investors to pool their money with other investors, so they could buy hundreds or even thousands of securities and build diversified portfolios.

Two things that have made direct indexing a more viable option for more investors in recent years are the rise of commission-free trading, and fractional-share stock investing, which allows investors to purchase fractional shares in a certain dollar amount. Because stock prices vary so widely, having the ability to invest fractionally makes it much easier to match the index’s proportions.

What are the benefits of direct indexing?


When you own the stocks directly, you are ultimately the portfolio manager.

That means you can customise the index if you want to. Are there securities in the index that don’t align with your values, from an environmental, social, and governance perspective perhaps? Direct indexing allows you to sell or avoid them.

One thing to be aware of: If your version of the index starts to look a lot different from the 'real' index in terms of sector weightings and so on, the performance won’t match up, either. This is called tracking error.

What are the drawbacks of direct indexing?


Direct indexing really only makes sense for people who have a considerable amount to invest in a taxable account and want a level of customisation they couldn’t otherwise obtain through a portfolio of funds or individual securities.

In addition, portfolio customisation can get really complicated, really quickly. The idea of being able to customise your portfolio from an ESG or factor exposure perspective may be appealing, but keeping track of all the moving data points on 500 separate securities can be daunting.

You would also have to keep tabs on changes in the index—rebalances and reconstitutions—to make sure you know which securities are added and removed from the index.

Traditional index funds and exchange-traded funds do this for you for a (typically reasonable) annual fee. 

And finally—and this is the big one, in my mind—watch out for expenses. Not only do you pay asset-based fees for the direct-indexing account, but these fees may be a multiple of what you’d pay for a diversified portfolio of ETFs or index funds, says Ben Johnson, head of client solutions for Morningstar.

Also, Johnson says, there may be frictional costs - such as brokerage commissions, bid-ask spreads, and market impact - things that you don’t really see or are difficult to measure that are involved with direct indexing.

Bear in mind that S&P 500 index trackers are low-turnover strategies, meaning they don’t buy and sell too many stocks (the portfolio turnover rate is around 4%).

The more you start trading and customising positions in a direct-indexing portfolio, the more possibilities you have to encounter transaction costs, which will ultimately eat into your return.

Is direct indexing right for you?


Direct indexing allows investors and advisors to build a portfolio that is quite different from the broad market or a broad-based index fund, Johnson explains.

Over time that may result in better risk-adjusted returns, but for many active managers, it results in worse returns.

“[Direct indexing] makes a large number of investors effectively active managers,” Johnson says.

“And what we know about active management, about being different from the market, is that sometimes it’s going to look right and feel good, and sometimes it’s going to look wrong and feel bad.”

In Johnson's opinion, this is a risk, or opportunity cost, of constructing your portfolio using direct indexing versus using traditional mutual funds or ETFs.

“There could be circumstances where [investors] would probably be better served—they would have gotten greater returns with less risk—by simply owning broad-based index mutual funds or discretionary active funds.”