Direct indexing gives you immediate access to indices such as the FTSE 100 or S&P500.
Unlike traditional mutual funds or exchange-traded funds (ETFs), you can personalise your investment while still benefitting from a high level of diversification.This approach also helps you optimise your taxes.
You get flexibility and control over your portfolio. So you can cut out sectors you disagree with, such as oil and gas or the meat industry. Or customise your portfolio to protect against specific risks and take account of individual company preferences. That way, you can write your own narrative.
Narrative is making direct indexing accessible to the ordinary investor. Find out more here.
You may have heard of index funds, typically known as mutual funds or exchange-traded funds(ETFs). These aim to give you exposure to a financial market index, such as theFTSE 100 or S&P 500, without you having to buy the individual shares.
To achieve this, index funds create a portfolio which is designed to track the index. Say you invest in a fund tracking the FTSE 100. On your behalf, the fund invests in a basket of shares weighted to reflect the performance of the index.
Take oil giant Shell. It represents roughly 8.5% of the value of the FTSE 100 (as ofJune 2022), so 8.5% of the shares the fund holds will be in Shell. BritishAmerican Tobacco is just over 4% of the value of the index, so the fund owns just over 4% of those shares, and so on.
Direct indexing, as the name suggests, gives you more immediate access to the companies in an index. You own the underlying shares the index is composed of, rather than a portion of a fund which invests on your behalf.
Why does that matter? Let’s take a look…
If you care about where your money’s going, you’ll have little control with an ETF. The fund manager makes decisions on your behalf. Lump it or leave it.
Care deeply about animal welfare? You may be concerned to learn that over 140 firms in the S&P 500 are linked to animal welfare concerns.
Are you passionate about climate change? Then investing in a fund that tracks the FTSE100 might not sit right with you, when you realise that oil majors such as Shell and BP are part of the index, as well as Glencore, one of the world’s largest coal producers. Even picking an ETF that trumpets its environmental credentials isn’t a sure-fire strategy: the largest ‘green’ ETF includes the two biggest US oil companies.
Direct indexing lets you buy into the biggest indices, but remove these industries completely from your portfolio.
So if you’re concerned about the environment, you can stay invested in most of the firms in an index, but specifically exclude those in the oil and gas sector.
If we all pulled our money out of industries that didn’t align with our values, the impact would be huge. It would send a strong message to the companies whose share price is propped up by the flow of funds into ETFs, and the impact on your returns could be surprising! Historically, many controversial industries have underperformed compared to the rest of the market.
But the personalisation doesn’t stop there. We can also adjust for particular market risks, such as high inflation. Or even to take account of individual company preferences. Direct indexing takes back the reins from the fund manager, so you have the flexibility and control to write your own narrative.
If you want to see what a portfolio that reflects your values looks like and how it would perform, check out our interactive tool.
One of the downsides of picking and choosing your own shares is that you can end up withan unbalanced portfolio. Without intending to, you can inadvertently lean too heavily on one company or industry.
Let’s pick a company. We’ll call it Uri’s Umbrellas. You’ve invested heavily in the firm, convinced that it represents the future of folding canopy innovation.Unfortunately, the year turns out to be a spectacularly dry one, plagued by droughts (sound familiar?). The performance of Uri’s Umbrellas tanks, and the value of your holding plummets with it.
If you invested instead in an index fund, Uri’s Umbrellas would be just one of many firms in your portfolio. So if it’s a bad year for buying rain covers, your exposure is limited to the weight of that firm in the index.
The risk of one company underperforming can also be balanced out by another company with different characteristics. A bad year for umbrella firms is probably a good one for ice cream companies, for instance.
By spreading your investment across a wide range of assets, you limit your exposure to the risks associated with one particular market, while benefitting from the consistent performance of indices such as the FTSE 100.
Direct indexing builds portfolios to match indices as closely as possible, while adjusting for your specific requirements. That means you keep the benefits of a diversified portfolio.
Every year UK taxpayers are given a Capital Gains Allowance of £12,300. If you sell assets such as taxable shares (those held in a General Investment Account or GIA), you can make a gain up to that amount without having to pay Capital Gains Tax.
Direct indexing allows you to make the most of this allowance, as individual shares can be sold when they go up in value, then repurchased again at a later date.
While you can do something similar with ETFs, direct indexing lets you pick individual stocks to sell. This means you can still book a profit even when the market is flat, as some stocks will be performing better than others. Maximising this allowance can save you up to £2,460 per year.
For obscure tax reasons, you have to wait 31 days before repurchasing, to prevent a practice known as Bed & Breakfasting. During this period, Narrative puts your money to work elsewhere to ensure you stay invested in the market.
We know the words ‘obscure’ and ‘tax’ can send many a reader to sleep, but for those still interested, we’ll have a blog post on it soon.
So, what’s the catch? We’ll look at:
Trying to hold on to a shifting portfolio of 100 shares (in the FTSE 100’s case), or even500 (as with the S&P 500) is daunting to say the least.
The companies that make up the index chop and change, as do their relative weightings. Add on top of that customisation to avoid particular sectors or mitigate specific risks, and things can get pretty complicated, pretty quickly.
Partly for this reason, existing providers of direct indexing tend to limit the strategy to those who already have substantial sums available.
Got £5million to spare? Then a wealth manager might agree to create a direct index portfolio for you, as a bespoke one-off.
But for most of us, we’re cut off from the benefits of direct indexing. Either we have to accept the risks of picking individual stocks, or we are limited to investing in pre-existing funds.
narrative is making direct indexing accessible to the ordinary investor. Tell us about your goals, values, and concerns, and we’ll build a portfolio just for you. We’ll handle the complexity, so you can get on with investing for the long term, on your terms.