For the longest time, people have invested in mutual funds within their retirement and brokerage accounts. In the early 2000s a new similar investment structure called Exchange Traded Funds (ETFs) have grown in popularity. While they are similar to mutual funds, there are some advantages they have over the older investment type. Now, we have another opportunity to be potentially more efficient with what is known as direct indexing; a strategy that is growing in popularity and is being made available to more people. In this month’s article, I’m going to share a bit about what each of these are and why you might consider them for your investment needs.
What are these things?
First I’ll define what these funds are designed to do and I’ll then go into more detail on each one. The idea here is to give people with more limited funds the opportunity to create a diversified portfolio so they can spread out and minimize their risk compared to investing in only a few stocks. Let’s give an example. Imagine you have $1,000 to invest in the market, without these fund vehicles it would be difficult to be diversified. As of the date of this writing in January 2025, for example, Tesla stock is trading around $430/share, Apple around $230 and Microsoft around $430. That would mean with your $1,000 you couldn’t buy 1 share of all 3 of these investments directly. These funds have allowed fund managers to pool a bunch of people like you together to increase buying power, so perhaps they can take 10,000 people with $1,000 each and now they can buy $10 million worth of stocks with each person having a share in the fund. Now instead of 1 share of each of the above stocks, you can have a fraction of all of them plus many more.
Mutual Funds
When it came to mutual funds, the fund manager would take the money that each person put into the fund and buy shares as new people came into the fund. When someone sold out of the fund, they would have to sell the associated shares so they can pay that person for their shares. This could get unwieldy, except for the fact that there can be a large number of people coming in, or an equal or greater number buying into the fund than selling out. The downside is that if people were leaving, the fund would potentially have to sell some of it’s holding (sometimes at an inopportune time) to pay the seller. Because everyone’s money was pooled together, when they sold shares there were often capital gains or capital losses incurred. Because you are a part of the fund, you would have your share of the gain or loss, even if you personally didn’t want anything to sell. As a result, there were tax consequences to mutual funds and often distributions to investors who may not have wanted them. Additionally, one downside to a mutual fund was that it was only bought or sold at the close of business. So if it was 9:30am and you placed an order for Mutual Fund A, which had a price of $30/share, by the time the market closed, it could be $31 or $29 by the end of the day and you had to wait to see the price you were redeeming at after the order was executed when the market closed, because there is a “net asset value” that needs to be calculated.
Exchange Traded Funds
Enter ETFs to solve some of the problems with mutual funds. They are similar in many ways and the concept for investing is the same; pooling your money with others. The added benefits are that they are treated like other securities such as stocks, so you can trade them at any time throughout the day and you would get the currently available price. This makes ETFs potentially more tax efficient, because you have more control of your investment. If you don’t sell your shares you generally aren’t going to have capital gains or losses. This can be better for your tax management as well as provide flexibility for buying and selling. Often times the fees associated with ETFs are less as well. When you invest in an ETF, the fund or fund manager decides what to put into the fund. Sometimes it’s based on an index like the S&P 500, an index that tracks the stock performance of 500 of the largest companies on the US stock exchange.
Direct Indexing
Direct indexing offers several potential benefits for investors, primarily centered around tax management, customization, and control. Imagine you really like 150 or 200 of the stocks in the S&P 500, with an ETF or mutual fund you don’t have a choice, you get what the fund has. This is where direct indexing can come in. It allows you to pick your favorite stocks and buy fractions of shares of them, so you can buy the ones you want and not the ones you don’t. It can be filtered for companies that align with your values, ones you think will perform well, or whatever other choice you make.
Unlike the ETF, if there are some companies that you chose that didn’t perform well, you can use a technique called tax loss harvesting, where you can sell them and take the losses, or also sell ones that have gains and offset the gains and losses. This is a way to be even more tax efficient.
With a number of investing options available, you have great opportunities to invest in a customized way that works for you. If you need help better understanding these options, don’t hesitate to reach out.
Disclaimers: The information in this article is not tax, legal or investment advice. Each person’s financial situation is unique. Consult a financial professional before making investment decisions.
All investing involves risk including the possible loss of principal. Not strategy assures success or protects against loss. Any companies mentioned are for informational purposes only and should not be considered as an endorsement or recommendation for purchase or sale of any such company