Author Topic: Direct indexing seems inevitable  (Read 865 times)

Buffaloski Boris

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Direct indexing seems inevitable
« on: August 09, 2020, 07:35:44 PM »
A good article on the future trend of direct indexing.  He argues that the demand will come mostly from ESG investors.

https://monevator.com/direct-indexing-near/

ctuser1

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Re: Direct indexing seems inevitable
« Reply #1 on: August 10, 2020, 07:37:28 AM »
The actual mechanics of indexing, especially at scale, is not simple!!

When one person is doing the direct indexing with his million-dollar-portfolio, it is simple and easy. Not so when you have tens of billions being managed that way, let alone with the trillions of dollars that slosh around in the index funds today.

If/when direct indexing becomes more popular, you will see higher and higher tracking losses. When you try to remedy them, all the perceived advantages over indexing will disappear.


MustacheAndaHalf

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Re: Direct indexing seems inevitable
« Reply #2 on: August 10, 2020, 11:48:44 AM »
There's some drawbacks to direct investing that I think will keep "Joe Investor" away from it.

Vanguard S&P 500 costs 0.03% per year, and automatically invests your money in 500+ stocks.  So if you have $10,000 to invest, that costs you $3/year.  You can buy more and pay that same expense ratio on new funds.

Now compare to direct investing.  Most brokerages charge $0 to buy and sell stocks - so far, so good.  But there's a lot of math ahead to buy a market cap weighted index: adding up every market cap, getting the percentage of the market for each stock, and multiplying by your investment.  Was that math worth $3/year?

And now the physical purchase, which is made 500 times.  Good luck making zero mistakes!  That's 500 buy orders, one for every stock in the S&P 500.  Another added bonus: each of them will send you proxy materials, so expect hundreds of emails asking multiple times to remember to vote!

And if this is being done at Vanguard, you can't directly buy fractional shares.  So when your spreadsheet says to buy $450 worth of Amazon... which costs $3,150 for one share, so you can't buy it.  Maybe that means direct indexers have to move to brokerages that offer fractional stock shares, and leave Vanguard.

Most people don't invest one lump sum - they invest several times a year.  Someone investing quarterly will manually input 2,000 stock purchases per year... and save $3?  And when their portfolio grows to $100,000 they're now paying... $30/year.  Or they could move to Fidelity's zero cost fund.

So to me, there's a lot of obstacles before the average retail investor begins to index with direct purchases of stock shares.

Buffaloski Boris

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Re: Direct indexing seems inevitable
« Reply #3 on: August 11, 2020, 01:34:49 PM »
There's some drawbacks to direct investing that I think will keep "Joe Investor" away from it.

Vanguard S&P 500 costs 0.03% per year, and automatically invests your money in 500+ stocks.  So if you have $10,000 to invest, that costs you $3/year.  You can buy more and pay that same expense ratio on new funds.

Now compare to direct investing.  Most brokerages charge $0 to buy and sell stocks - so far, so good.  But there's a lot of math ahead to buy a market cap weighted index: adding up every market cap, getting the percentage of the market for each stock, and multiplying by your investment.  Was that math worth $3/year?

And now the physical purchase, which is made 500 times.  Good luck making zero mistakes!  That's 500 buy orders, one for every stock in the S&P 500.  Another added bonus: each of them will send you proxy materials, so expect hundreds of emails asking multiple times to remember to vote!

And if this is being done at Vanguard, you can't directly buy fractional shares.  So when your spreadsheet says to buy $450 worth of Amazon... which costs $3,150 for one share, so you can't buy it.  Maybe that means direct indexers have to move to brokerages that offer fractional stock shares, and leave Vanguard.

Most people don't invest one lump sum - they invest several times a year.  Someone investing quarterly will manually input 2,000 stock purchases per year... and save $3?  And when their portfolio grows to $100,000 they're now paying... $30/year.  Or they could move to Fidelity's zero cost fund.

So to me, there's a lot of obstacles before the average retail investor begins to index with direct purchases of stock shares.

For folks who donít care or donít have the skill set or portfolio size or patience to direct index, I donít see much change. Those folks will buy a traditional index and call it a day. For myself or ESG investors, itís a great opportunity as we can pick and choose and with time there will be algorithms that make it easier. As for getting proxies, thatís a feature not a bug for the ESG folks.

I still think we have some time and improvements before index investing becomes a thing.

appleshampooid

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Re: Direct indexing seems inevitable
« Reply #4 on: August 12, 2020, 07:36:44 AM »
There's some drawbacks to direct investing that I think will keep "Joe Investor" away from it.

Vanguard S&P 500 costs 0.03% per year, and automatically invests your money in 500+ stocks.  So if you have $10,000 to invest, that costs you $3/year.  You can buy more and pay that same expense ratio on new funds.

Now compare to direct investing.  Most brokerages charge $0 to buy and sell stocks - so far, so good.  But there's a lot of math ahead to buy a market cap weighted index: adding up every market cap, getting the percentage of the market for each stock, and multiplying by your investment.  Was that math worth $3/year?

And now the physical purchase, which is made 500 times.  Good luck making zero mistakes!  That's 500 buy orders, one for every stock in the S&P 500.  Another added bonus: each of them will send you proxy materials, so expect hundreds of emails asking multiple times to remember to vote!

And if this is being done at Vanguard, you can't directly buy fractional shares.  So when your spreadsheet says to buy $450 worth of Amazon... which costs $3,150 for one share, so you can't buy it.  Maybe that means direct indexers have to move to brokerages that offer fractional stock shares, and leave Vanguard.

Most people don't invest one lump sum - they invest several times a year.  Someone investing quarterly will manually input 2,000 stock purchases per year... and save $3?  And when their portfolio grows to $100,000 they're now paying... $30/year.  Or they could move to Fidelity's zero cost fund.

So to me, there's a lot of obstacles before the average retail investor begins to index with direct purchases of stock shares.
The whole point of the linked article is that this is all solvable with software. I agree Joe Investor isn't going to be putting in 500 buy orders (or ~3500 in the case of a TSM index). But writing software to do this for you, and allow you to make exceptions here and there for the ESG use case, isn't that hard. Buying fractional shares is also possible (and I think allowed with some brokerages right now) and would be rolled in to this software solution.

It's not here yet, but I agree with the author that it's not a technically hard problem. Honestly, I'm surprised it hasn't come about yet!

Taxes would be another headache though. Although as long as you have good compatibility between the brokerage running this software and your tax software, hopefully it would just be a straight import. The stack of forms would be hilarious though, holding that many individual companies. Even if you don't sell, the dividends would be madness.

Buffaloski Boris

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Re: Direct indexing seems inevitable
« Reply #5 on: August 12, 2020, 08:18:13 AM »
There's some drawbacks to direct investing that I think will keep "Joe Investor" away from it.

Vanguard S&P 500 costs 0.03% per year, and automatically invests your money in 500+ stocks.  So if you have $10,000 to invest, that costs you $3/year.  You can buy more and pay that same expense ratio on new funds.

Now compare to direct investing.  Most brokerages charge $0 to buy and sell stocks - so far, so good.  But there's a lot of math ahead to buy a market cap weighted index: adding up every market cap, getting the percentage of the market for each stock, and multiplying by your investment.  Was that math worth $3/year?

And now the physical purchase, which is made 500 times.  Good luck making zero mistakes!  That's 500 buy orders, one for every stock in the S&P 500.  Another added bonus: each of them will send you proxy materials, so expect hundreds of emails asking multiple times to remember to vote!

And if this is being done at Vanguard, you can't directly buy fractional shares.  So when your spreadsheet says to buy $450 worth of Amazon... which costs $3,150 for one share, so you can't buy it.  Maybe that means direct indexers have to move to brokerages that offer fractional stock shares, and leave Vanguard.

Most people don't invest one lump sum - they invest several times a year.  Someone investing quarterly will manually input 2,000 stock purchases per year... and save $3?  And when their portfolio grows to $100,000 they're now paying... $30/year.  Or they could move to Fidelity's zero cost fund.

So to me, there's a lot of obstacles before the average retail investor begins to index with direct purchases of stock shares.
The whole point of the linked article is that this is all solvable with software. I agree Joe Investor isn't going to be putting in 500 buy orders (or ~3500 in the case of a TSM index). But writing software to do this for you, and allow you to make exceptions here and there for the ESG use case, isn't that hard. Buying fractional shares is also possible (and I think allowed with some brokerages right now) and would be rolled in to this software solution.

It's not here yet, but I agree with the author that it's not a technically hard problem. Honestly, I'm surprised it hasn't come about yet!

Taxes would be another headache though. Although as long as you have good compatibility between the brokerage running this software and your tax software, hopefully it would just be a straight import. The stack of forms would be hilarious though, holding that many individual companies. Even if you don't sell, the dividends would be madness.

Good post and thanks for taking the time.

I do think we're on the cusp of direct indexing being a thing and there are brokerages that offer both free trades and fractional share ownership.  Here is a link to a good article outlining what's available. 

https://www.investopedia.com/comparing-fractional-trading-offerings-at-online-brokers-4847173

As for the tax piece, I wouldn't even try to do this outside of say an IRA or other tax advantaged account.  The tax paperwork would be a nightmare. 

LWYRUP

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Re: Direct indexing seems inevitable
« Reply #6 on: August 12, 2020, 08:28:03 AM »
Dirt cheap direct indexing within a retirement account (no tax issues) with software would be great.  I wouldn't mind setting up a basket of like 50 individual stocks with 2% ownership of each one and plugging that into a software and having the software buy the shares and rebalance for me. 

I have no interest in trying to replicate it myself in the meantime, for the reasons posted above and also let's not forget that bid-ask spreads act as an invisible tax on individual investors (hedge funds with supercomputers will swoop in to arbitrage away the differences). 

For the moment, dumping your money in VTSAX and using the extra free time to play on the MMM forum has a lot of advantages.  : )

Buffaloski Boris

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Re: Direct indexing seems inevitable
« Reply #7 on: August 12, 2020, 08:39:33 AM »
Dirt cheap direct indexing within a retirement account (no tax issues) with software would be great.  I wouldn't mind setting up a basket of like 50 individual stocks with 2% ownership of each one and plugging that into a software and having the software buy the shares and rebalance for me. 

I have no interest in trying to replicate it myself in the meantime, for the reasons posted above and also let's not forget that bid-ask spreads act as an invisible tax on individual investors (hedge funds with supercomputers will swoop in to arbitrage away the differences). 

For the moment, dumping your money in VTSAX and using the extra free time to play on the MMM forum has a lot of advantages.  : )

Direct indexing will get there with time and I think sooner rather than later.  At this point I couldn't dive in if I wanted to as I'm stuck in a 401(k)*.  If someone is interested in doing an equal weight portfolio for the entire S+P 500, RSP already does that. I think the S+P 500 is pricey, but were I to own much of it, that's the path I would go for now and roll it into direct indexing in the future.

The lack of adequate diversification is a big reason why I don't do the popular weight cap, large cap funds.  When you put 20%+ of your wealth on a mechanical basis in just a few stocks, that's just a bug looking for a windshield in my view. And that's what a weight capped large cap index is doing.  It's less so with the "whole market" funds, but still very significant.       


*(very first world problems)