Index Innovation

Does the latest in index innovation help or distract investors?

A lot has been happening lately for retail sized investment accounts. Most of the big online brokerage firms no longer charge commissions for individual stocks or ETFs (there are a few exceptions) and Charles Schwab announced it will allow investors to buy fractional shares of stocks, not ETFs, and it is a reasonable bet that the other brokers will follow suit on the fractional shares.

A separate conversation for months has been potential changes to the indexing business with custom indexes and direct indexing. Custom is pretty straight forward, direct essentially means bypassing the middle man, the fund company, to own all 500 or 1000 stocks directly. Nate Geraci has a good primer to learn more about direct indexing.

It is not clear to me at this point that custom indexing or direct indexing will meet the need of the typical retail sized investor (here I mean do-it-yourselfers and advisory clients). The mechanics of building an index yourself in the right weightings and then making changes when the index does would be monumental. Nate notes that there are companies that will do it for you and charge 25-35 basis points. That's cheap but funds tracking large cap, domestic indexes are mostly (entirely?) below 10 basis points. Why pay more?

If you own all 500 or 1000 stocks directly, there is the possibility for tax loss harvesting. This is true but I doubt too many people would take on what amounts to a full time job selling the losers and then tracking when they can be bought back as well as create a much bigger job for their accountants at tax time doing all that spreadsheet work. I can't see this making economic sense for someone with a few hundred thousand dollar or even a couple of million dollars. Think about, for a $2 million portfolio an index component with a 0.30% weight would be $6000, if it lost $600 are you likely to sell to realize the $600 loss and then wait the month to buy it back?

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