If you’re a seasoned investor, you’ve probably heard that exchange-traded funds are efficient ways to get broad exposure to a wide variety of asset classes. You’ve also probably heard that ETFs are less expensive than mutual funds, which means a greater share of the return goes into your pocket, rather than a fund manager’s pocket.
The data bear that out: For actively managed mutual funds, the average expense ratio falls in a range between 0.5% and 1.0%. For passively managed index funds, which are often packaged in the form of an ETF, the average expense ratio is around 0.2%.
I’ve written about the effect of fees on your investmentspreviously. While I don’t consider the fee to be the most important aspect of your allocation, it’s certainly one that you need to consider. That’s because when you’re seeking exposure to any given asset class, you’ll almost always find a range of similar products with varying expense ratios.
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Whereas in many areas of life, you get a better product when you pay more, that’s not true with mutual fund and ETF investing.
But some investors believe they can do better by avoiding fund fees altogether. That is true on occasion.
To use an extreme example – and one that I don’t recommend – say you went all-in on chipmaker Nvidia (NVDA) on January 1 of 2021. You held nothing else in your portfolio. Nvidia was up 125% last year. It’s a component of the S&P 500, which was up 26.9% in 2021.
Obviously, you avoid fees that way. But no serious investor goes all in with one stock.
Should You Try Direct Indexing?
However, one concept that is gaining traction is direct indexing, sometimes dubbed with the more pejorative moniker of “closet indexing.”
Direct indexing means creating your own portfolio of stocks to mirror an index. An easy example is the Dow Jones Industrial Average, which tracks 30 large-cap U.S. stocks. On the surface, it seems simple enough to just buy all 30 individual stocks and hold them.
But that’s where it gets tricky. How much effort are you putting in to match the Dow’s weightings? Do you rebalance daily as weightings change, or less frequently? Clearly, if you want to track the Dow as closely as possible, you’d rebalance daily – but that’s not really feasible for an individual investor, even in this era of low or even zero trading fees. You’d have to calculate the weightings every day, and put in trade orders to capture even the smallest changes.
Also, the idea of creating your own index brings up the issue of diversification. The Dow and the S&P 500 track the same asset class, large-cap domestic stocks. But true portfolio diversification means holding investments in domestic small caps, alternatives, non-U.S. stocks and some fixed income.
You can easily see the problem with trying to create your own direct indexes to track all these asset classes. For starters, it’s not easy to purchase foreign-listed stocks outside of a mutual fund or ETF, and a full portfolio of stocks not listed on U.S. exchanges would be expensive to trade. You’d also be dealing with time zone and currency differences, which could also affect your ability to rebalance in a timely fashion.
Some of the largest asset managers are now offering retail investors the ability to create their own direct indexing. Morgan Stanley, Vanguard and BlackRock are among the brokerages creating platforms allowing their customers to develop their own indexes in a cost-efficient manner.
For high-net-worth investors who also hold more conventional long-term portfolios, this type of self-created index could be a way to add alpha.
But professional managers focusing on aggressive growth strategies can’t even generate returns that beat the broad market in every cycle.
The Ark Cautionary Tale
For example, the Ark Innovation ETF (ARKK) is an actively managed fund that seeks long-term growth by investing in companies adhering to the fund’s theme of disruptive innovation.
According to the fund management company, Ark defines disruptive innovation “as the introduction of a technologically enabled new product or service that potentially changes the way the world works.”
That thesis has worked out well in certain market cycles, but not lately; the fund is down a whopping 56% in the last year, with losses accelerating since November as growth stocks have taken it on the chin.
In other words, just because you can create your own “index,” does that mean you should? An index can really be anything at all, as evidenced by actively managed funds that develop their own baseline for tracking. A few months ago, you could have created an index consisting solely of small-cap software companies that went public in 2021, while that asset class is in high growth mode. Now that the asset class has essentially collapsed along with most other growth sectors, an index full of small-cap software stocks doesn’t sound like such a great idea.
In addition, there’s a great temptation to tinker with your holdings just because you have a hunch, or read some news that you believe will affect your stocks. At that point, you’re right back to a single-stock portfolio that runs the risk of being a willy-nilly collection of “stuff.” That’s the opposite of an allocated portfolio back-tested to meet your unique financial goals.
None of this is to suggest you shouldn’t hold single stocks, and our various Cabot analysts give you a multitude of ways to boost your returns outside of your long-term holdings. But it’s almost certainly a big mistake to forgo proper allocation and professional index management in your long-term portfolio earmarked for specific goals, such as retirement.
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*This post has been updated from an original version, published in 2021.
