SMSF

Direct Indexing for SMSFs

Direct indexing has been gaining popularity in recent years as an alternative investment strategy. Unlike traditional index funds, which seek to track a specific market index, direct indexing involves investing directly in the underlying stocks that make up the index.

This can offer a number of advantages, including potentially higher returns, greater control over your investment portfolio, and lower fees. However, it’s essential to understand the risks involved before deciding if it is right for you.

Why use direct indexing?

Many benefit from purchasing real assets directly from the investor than using packaged vehicles like mutual funds and ETFs. When you buy packaged vehicles you aren’t able to personalize or tailor your exposure to your own needs; you’re also obliged to take steps within the fund that might affect you personally and negatively. Typically a firm can sell its securities throughout the year and must pay all its shareholders for its earnings. This capital gain distribution is often used by actively-owned funds when managers sell positions to make gains.

What is direct indexing?

It’s the method of index investing by which investors buy stocks that form a specific benchmark index in equal weight. It contrasts with buying a mutual fund or index fund that track an index. In the past, if the company was to buy any stock that could be replicated in the stock market, the transaction would require hundreds of transactions and quickly became overpriced for fees and commissions.

By investing directly in the underlying assets that make up a specific index rather than investing in a fund that tracks the index like an ETF or an exchange-traded fund. This means that you have greater control over your investment portfolio and can customize it to suit your specific goals and risk tolerance. For example, if you want to invest in an index but are concerned about the impact of a particular stock on your returns, you can simply exclude that stock from your direct indexing portfolio.

What are the benefits of direct indexing?

There are several potential benefits of direct indexing, including potentially higher returns. Because you’re investing directly in the underlying assets, you may be able to achieve higher returns than if you were investing in a traditional index fund. A conventional index or mutual fund typically have to buy and sell stocks as the index changes, which can lead to capital gains taxes that eat into your returns. Giving investors greater control in their overall portfolio, which can be helpful if you want to tailor your investments to specific goals or avoid certain stocks for ethical or other reasons. Lower fees when compared to traditional an index or mutual fund is another benefit as they often have higher management fees and transaction costs associated with them.

What are the risks?

There are also some potential risks to consider before investing in this strategy, including index tracking error. It can be difficult to perfectly track a specific index because you’re investing in the underlying assets rather than the index itself. This tracking error can lead to lower returns than if you had invested in the index directly.

Greater volatility is another risk to consider which can often lead to greater volatility in your portfolio. This is because the value of your investments will fluctuate along with the underlying assets. If you’re not comfortable with this level of volatility, it may not be suitable for you and consulting financial advisors about the investment might be a good place to start.

Understanding Direct Indexing

Earlier, direct indices seemed more useful for large investors and were generally cheaper to operate and maintain than owning indices. In the wake of the sluggish stock market rates, investors are becoming more concerned about self-replication in their portfolios. Increasing popularity in the form of fractions of shares allows the creation of indices with modest investments more easily and quickly.

Direct indexing is an investment strategy that involves buying and holding a basket of stocks that make up an index, such as the S&P 500. ETFs are also baskets of stocks, but they trade on exchanges like regular stocks. The key difference between direct indexing and ETFs is that with direct indexing, you own the underlying assets in a separately managed account which gives you the ability to customise your portfolio to match your specific investment goals. For example, if you want to avoid investing in companies that are polluters, you can do that with direct indexing. With ETFs, you have to take the whole basket of stocks, warts and all.

Is direct indexing better than exchange-traded funds?

There are pros and cons to both types of investments. Some investors prefer the flexibility of direct indexing, while others find the ease of an exchange-traded fund more appealing. Ultimately, it’s up to the individual investor to decide which strategy is best for them. Here are a few things to consider when making your decision:

  1. Costs: Generally speaking, direct indexing tends to be more expensive than ETFs. That’s because you’re paying for the privilege of customization and active management. With ETFs, you’re getting a passive investment that tracks an index.
  2. Tax efficiency: This is where direct indexing really shines. Because you can pick and choose which stocks to include in your portfolio, you can optimize it for tax efficiency. That means you’ll pay less in capital gains taxes when you sell your positions.
  3. Access to hard-to-reach investments: With direct indexing, you have the ability to invest in individual stocks that are not available through ETFs. For example, you might want to add a specific company to your portfolio that isn’t included in the major indexes.
  4. Simplicity: Some investors find the simplicity of ETFs more appealing than the customization of direct indexing. If you’re not interested in actively managing your portfolio, an ETF might be a better choice for you.
  5. Risk tolerance: Direct indexing can be riskier than ETFs because you’re investing in individual stocks instead of a basket of them. If one stock tanks, it can drag down your entire portfolio. With ETFs, the risk is spread out over many different stocks, which can help cushion the blow if one stock takes a nosedive.

Is direct indexing expensive?

When it comes to the cost of a Direct Indexing product in Australia, it’s cheaper than most ETFs. For an investment of $100,000, you will pay around 0.5% (minimum investment of $10,000), which falls to around 0.2% if you invest more than $1,000,000. While these fees are higher than some passive ETFs, it is similar in cost to more specialised ETFs. Due to the low minimum investment amounts, it could be suitable for retail investors and wealthy investors alike.

The investment fees start from 0.11% but the admin fees vary based on the total amount invested. An investor with $100,000 with a balanced investment allocation would pay around 0.5% in total fees (depending on the mix of underlying securities).

What’s a Direct Indexing company in Australia?

Direct indexing is an investing strategy that involves investing directly in the underlying assets that make up a specific index. The investor owns the all the stocks that make up an index in a separately managed account. There are several potential benefits of direct indexing, including potentially higher returns and lower fees.

SMSF Mate recently sat down with Damien Klassen, Chief Investment Officer at Nucleus Wealth. Damien believes that Direct indexing is the next gen of ETFs with many more benefits. Because the investor directly owns each of the shares in their own account, Nucleus Wealth is able to customise their SMSF holdings according to their preferences.

There are also some risks to consider before investing, such as tracking error and greater volatility which financial advisors could provide some assistance with. Before deciding if direct indexing is right for you, it’s important to consider your investment goals, risk tolerance, and time horizon.

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  • SMSF Mate is a unique website because it has ideas about how to approach SMSFs, insurance and other financial topics that come straight from first hand experience. It's much more useful than what you find on all the other financial websites that just offer generic info that you could easily get on the ATO's website. It's also nice to know there's no financial incentive behind the information, it's legitimately there to help people understand self-managed super funds and how to get the most out of them, not to get an affiliate commission from a broker or other financial services provider. The investment product information is also incredibly useful, I've never seen this kind of functionality on any other website that let's you look at such a wide range of products, sort by what info is most interesting or important to you, and subscribe to updates for different funds and financial products all in one place. Definitely worth checking out if you own or are considering an SMSF!

    David G, Self-Employed, SMSF Owner
  • SMSF Mate provides a unique insight into superannuation and financial topics in a way that is easier to understand than conventional websites. The colloquial nature of the site makes it easy to understand and they often speak about complicated topics in lamens terms so I can wrap my head around them. The investment product information is a great way to research funds that I am interested in investing in with my SMSF and there is a lot of helpful information on the site for better structuring my investment portfolio. In comparison to other websites which offer similar information, SMSF Mate excels as the information is free to access whereas many other sites charge a subscription fee for the same thing. Overall, I think SMSF Mate is a great resource for SMSF trustees and is worth looking at for a variety of super-related topics. Thanks.

    Tim B, Business Owner, SMSF Trustee