Bespoke ETFs: Customizing Your Portfolio with Direct Indexing

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Key Takeaways

Direct indexing gives you the ability to own the individual stocks that make up an index in a separately managed account. This level of customization and control is far greater than that of traditional ETFs.
Use direct indexing to supercharge your tax efficiency. Leverage strategies such as tax-loss harvesting to minimize and manage capital gains.
Bespoke ETFs provide a customization flexibility above direct indexing. They give you the power to tailor your portfolio to better align with your individual objectives, values, and sectors that you want to support.
Customization options, such as ESG criteria or specific themes, allow you to design a portfolio that reflects your ethical or financial priorities while maintaining diversification.
In fact, technology is what makes direct indexing possible. It streamlines automation, optimizes data analytics capabilities and portfolio management, so you can more effectively react to market changes in real-time while operating more efficiently.
Direct indexing is a terrific fit for ultra-high-net-worth individuals and investors looking for highly-tailored strategies. It requires aggressive stewardship to avoid pitfalls, complexity and expense while navigating transaction costs to maximize value.

Bespoke ETFs provide a more personalized way to invest, letting you customize your portfolio with direct indexing. Unlike conventional ETFs, this approach allows you to hold the actual individual securities, affording you greater precision and control over your investments.

With direct indexing, you could ensure your portfolio is tailor-made to achieve those goals, whether that’s a tax efficient approach, personal values, or leaning toward a preferred sector. It’s a customizable solution for investors who want to customize their strategy without the burden of being committed to a set-fund.

This is helpful for investors looking to exclude certain industries or sectors. It serves investors who want to exclude certain stocks, or prefer to optimize their portfolio for tax-loss harvesting.

In this guide, we’ll explore the ins and outs of bespoke ETFs. We’ll explain their main advantages and walk you through how they can improve your investment strategy as a whole.

What is Direct Indexing?

Direct indexing is an investment strategy that gives you the ability to directly own the individual securities within a separately managed account (SMA). This method is different from purchasing shares of a pooled investment vehicle, like an ETF or mutual fund.

It’s this last approach that provides you the flexibility to literally copycat an index by owning all of its underlying constituents. Direct indexing gives you the flexibility to customize your portfolio to fit your values and financial goals. This approach is different from traditional index investing, where a fund manager decides what goes in the index.

1. Define Direct Indexing

With direct indexing, you manage a portfolio of individual stocks rather than owning a share of a fund that bundles them. This flexible structure creates tremendous customization opportunities, like aligning users’ investments with their personal values or improving their overall tax outcomes.

You can screen out companies whose business practices don’t align with your values. On top of that, you can increase allocation to certain sectors that further your intentions. Unlike an ETF, which is a single entity, direct indexing focuses on individual stock ownership, giving you greater flexibility in managing your portfolio.

2. How Direct Indexing Works

Direct indexing employs SMAs to hold each security separately, allowing for tailored tweaks down to the individual stock level to align with your goals. Robust technology streamlines important processes like tax-loss harvesting, on autopilot.

This third strategy refers to selling underperforming assets in order to offset the resulting gains with losses and rein in tax liability. This is particularly advantageous in turbulent markets or in periods of low growth. It’s a simple way to protect your tax efficiency and boost your after-tax returns.

3. Direct Indexing vs. Traditional ETFs

While ETFs have a rigidly defined structure, direct indexing provides much more flexibility. You can do things at the individual holding level, like exclude specific stocks or industries.

Direct indexing’s tax efficiency is a killer app. While ETFs have their own tax efficiencies, direct indexing is the gold standard for tax loss harvesting at the individual stock level. This practice can result in substantially greater annual after-tax returns referred to as tax alpha.

4. Benefits of Direct Indexing

The benefits of direct indexing go far beyond customization. Personalized tax management gives you greater control and flexibility to manage capital gains and losses.

By scanning daily for tax-loss harvesting opportunities, you can supercharge your after-tax returns by 1% to 2% annually—or higher. Additionally, this approach allows your portfolio to more accurately align with your values — whether that’s promoting sustainability efforts or divesting from industries that don’t align with your ethical beliefs.

5. Direct Indexing and Tax Optimization

Direct indexing shines when it comes to tax optimization. Plus, you can proactively harvest tax-loss harvesting opportunities by offsetting gains and losses at the individual security level.

No surprise, this strategy is effective even in markets characterized by low volatility. This day-to-day oversight constantly eliminates capital gains taxes. It also gives you more control over your taxable income, making it a truly impactful tool for improving long-term tax efficiency.

6. Who Should Consider Direct Indexing?

Direct indexing is especially attractive to high-net-worth clients with complicated tax scenarios. It’s well-fitting for investors who appreciate nuanced strategies, or who require tax management tactics to offset overexposure in certain stocks.

As technology has made this strategy easier, more scalable and more effective, a larger pool of investors are now able to access this strategy and its corresponding benefits.

Bespoke ETFs Explained

Bespoke ETFs—short for exchange-traded funds—are highly tailored investment vehicles. Rather, they focus laser-like on creating value for the highly specific needs and unique preferences of individual investors. Unlike traditional, one-size-fits-all ETFs that track predefined indices, bespoke ETFs offer a higher level of personalization. This allows you to align your portfolio with your financial goals, values, or even tax strategies.

This trend is absolutely booming as more and more investors seek customized solutions. They are making more tailored investment decisions that suit their individual contexts and priorities, rather than one-size-fits-all investments.

Defining Bespoke ETFs

To put it simply, bespoke ETFs are created to your goals. These funds are designed specifically for you. Whether you’re looking to focus on a particular sector, reduce your footprint in undesirable industries, or adopt the tenets of ESG investing, we’ve got the solutions.

These funds are unique from typical index funds. They offer customizable asset selection and weighting, offering you more control over your portfolio. For example, if sustainability is important to you, a bespoke ETF can invest solely in green energy businesses. It can remove fossil fuel stocks to reflect your values.

This level of customization makes users feel more invested in their choices and creates a deeper connection to investing.

Customization Options in Bespoke ETFs

With bespoke ETFs, the possibilities are endless. You can customize your investments to better reflect your individual goals. These can be sector specific, like technology or healthcare, and can even be based on Environmental, Social, and Governance (ESG) criteria.

You can make an adjustment for risk tolerance or income generation requirements. This flexibility ensures your portfolio adapts to life changes, such as planning for retirement or prioritizing philanthropy. It offers a tailored approach that resonates with diverse preferences.

How Bespoke ETFs Use Direct Indexing

With direct indexing, you can now customize your investments even further. Specifically, you can choose to invest directly in each individual component of an index rather than through a fund that tracks that index.

Their model has improved tax efficiency through various techniques including tax-loss harvesting and allows for stocks to be weighted according to individual preferences. For instance, you might want less exposure to fossil fuel companies in the S&P 500.

Through the power of direct indexing, bespoke ETFs offer a compelling and deeply customized approach to matching with precision through hard-to-reach benchmarks.

Tailor Your Portfolio

Customizing your portfolio through direct indexing solutions offers a unique opportunity for personalized indexing investors to align their investments with personal values and financial goals. This direct indexing strategy allows you to focus on specific investment sectors, themes, or strategies that align with your priorities while retaining the benefits of index-based investing.

Align Investments with Values

Aligning personal values with investments makes for a more rewarding and impactful investing experience. More and more investors are turning to conscious investing, motivated by the interest to promote socially responsible and sustainable developments.

For example, you may choose to first focus on the companies making strides in environmental governance or go after the companies demonstrating diversity in their executive suites. Tools like Schwab Personalized Indexing give you the ability to replicate indices like the S&P 500 or ESG-oriented benchmarks in a customized manner.

Simultaneously, they allow for tax-loss harvesting at the individual holding level.

Target Specific Sectors or Themes

If you care deeply about a specific industry or theme, direct indexing allows you to invest specifically in those areas. For instance, tech lovers could focus on cutting-edge companies, while those in the health field may want to focus on biotech firms.

In short, research and analysis are key here to pinpoint sectors with robust growth potential. Research indicates that direct indexing typically beats active strategies in asset classes like U.S. Large-cap equities. This pattern is particularly strong over shorter time horizons and wealthy investors become more pronounced.

Implement ESG Investing Strategies

Environmental, Social, and Governance (ESG) investing is a powerful trend, as investors increasingly demand portfolios aligned with their values. By applying ESG factors, you’ll be making investments in the companies that are working to combat climate change, advance social equity, or improve governance standards.

Portfolio managers use advanced technology to optimize holdings and monitor accounts, ensuring alignment with both your ethical and financial objectives.

Risk Management with Customization

Strong risk management is an essential component of any customized investment strategy. Bespoke ETFs via direct indexing offer an interesting, useful approach to pulling off this feat. Customize your investment mix to fit your unique priorities and risk profiles.

This strategy provides you more flexibility to avoid risk of proprietary securities and manage your portfolio level exposure to risk. On top of risk mitigation, this strategy allows more flexibility and tax-efficient opportunities.

Control Over Individual Securities

Since direct indexing allows investors to directly own individual securities, this provides investors with a degree of customization and control that is simply not possible with traditional funds. This increased visibility gives you the opportunity to track your holdings more closely and make prudent adjustments based on the latest market developments.

For example, if a large cap stock is going to be challenged by headwinds, you can lower your exposure or substitute it out. Portfolio managers equipped with more sophisticated technology are able to optimize accounts on a daily basis, capturing tax-loss opportunities in advance to improve after-tax returns.

Schwab Personalized Indexing differentiates itself by enabling tax-loss harvesting at the individual holding level. Doing so can increase performance on an annual basis, while still providing a performance-driven, risk-managed base.

Diversification Strategies

Diversification is still at the core of managing risk, and direct indexing makes it more efficient. By diversifying your investments among different asset classes, you can limit the effect of one sector that’s having a bad year on your overall portfolio.

By adjusting your exposure, you can come as close to a perfectly balanced portfolio as possible. Customize it to suit your customized preferences, such as sector weights or ESG factors. Fees are as low as 0.40%, with a minimum investment of $100K to get started.

This strategy is now within reach of far more investors, offering an efficient and cost-effective way to diversify their portfolios and improve tax efficiency.

Adapting to Market Changes

Whether anticipating market changes or reacting to them, flexibility is key and direct indexing offers advisors the capability to pivot quickly. Portfolio managers can adjust individual holdings to reflect evolving trends, ensuring alignment with your investment objectives.

Being in tune with what’s happening in the market is absolutely key. This proactive approach ensures that your portfolio remains fully optimized and resilient in the face of changing conditions.

Technology and Direct Indexing

Heightened interest in personalized investment strategies has moved technology to the center of direct indexing’s gravity. With the right tech stack—including cloud-based tools, platforms, and analytics—investors have the ability to get extremely specific in their portfolio customization, efficiency, and oversight. That’s what technology does—makes complex things easy.

It provides you the tools necessary to truly personalize your portfolio to align with your unique financial objectives, values, and tax minimization tactics.

Essential Tools and Platforms

Tools like Orion and Black Diamond offer streamlined management and detailed performance tracking. Providers such as Canvas by O’Shaughnessy Asset Management and Vanguard Personalized Indexing deliver intuitive, customizable indexing solutions. Software like 55ip focuses on tax-loss harvesting and tax efficiency.

Platforms like Tableau help in understanding portfolio performance and trends. Unlike old school tech, these tools focus on building in tools for real-time updates, personalization, and tax-optimizing features.

Intuitive design is important because it allows investors to easily track and manage their portfolios—all without having to master a technical skill set.

Data Analytics and Insights

Data analytics is key to optimizing direct indexing strategies. Rooted in deep analysis of historical performance, trends in the market, and your personal risk tolerance, these tools can provide tailored, actionable insights. For example, spotting sectors lagging in performance or areas of high growth leads to quicker corrective action across the portfolio.

Analytics drive diversification strategies. Diversification works to minimize risk and improve return at the same time.

Automation and Efficiency

Automated strategies are increasingly effective at managing large portfolios and automating repetitive, costly tasks such as tax-loss harvesting and rebalancing. Automation provides the assurance that portfolios remain on track with investment objectives, while creating efficiencies with time savings and error reduction.

For instance, algorithms can automatically sell underperforming assets to offset gains, minimizing tax obligations while making compliance easy.

Integrating Direct Indexing

Direct indexing is being more widely seen as a dynamic, versatile tool for modern portfolio management. With the right integration, investors can gain a more personalized strategy that better aligns with their unique financial objectives. This will further enable them to optimize for tax efficiency and diversification.

This approach works well alongside traditional vehicles such as mutual funds and ETFs. Besides, it provides exclusive benefits that serve your customized investment requirements.

Combining with Existing Strategies

Integrating direct indexing with existing tactics can promote an unparalleled level of portfolio flexibility and customization. For example, an investor already holding index ETFs might layer direct indexing to gain control over specific securities. This enables better alignment with personal values such as low-carbon initiatives or other ESG principles.

This integration makes diversification more powerful by providing more efficient and targeted exposure to larger or specialized market segments, all while actively managing risk. Unsurprisingly, direct indexing can still tax-loss-harvest even while the index produces a positive return. This feature alone puts it at an enormous advantage over traditional ETFs.

Rebalancing and Portfolio Maintenance

Additionally, regular rebalancing helps to make certain that portfolios stay true to desired target allocations. Direct indexing makes this choice much easier by allowing clients to focus on those individual securities. This allows investors to sell their underperforming stocks to offset (or balance) their gains elsewhere.

They accomplish this to remain compliant with IRS wash sale rules. Some of these platforms offer automated tax-loss harvesting, so the ongoing maintenance is even more time-efficient. These features have a meaningful impact on helping investors achieve their long-term goals with greater accuracy and control.

Performance Tracking

An established culture of consistent performance tracking is key for effective portfolio management. Direct indexing solutions provide more granular tracking of specific securities, enabling personalized indexing investors to evaluate the performance of their investment portfolios more effectively. Metrics such as risk-adjusted returns inform future decisions, helping these portfolios continue to adapt and grow as their investing goals change.

Overcome Challenges

Direct indexing solutions provide investors with a more customized approach to portfolio management, enhancing their investment portfolios. However, these benefits come with challenges that, when addressed, can lead to a more fruitful investing strategy for the investor.

Complexity and Management

As rewarding as managing a personalized indexing portfolio can be, the process may seem complex. This complexity arises from the need to track individual securities instead of relying solely on traditional index funds. Such an approach demands greater sensitivity to market changes and a willingness to engage deeply with your investments.

To simplify this process, consider adopting tech tools. Utilizing technology like portfolio management software or robo-advisory platforms can automate rebalancing and tax planning, significantly reducing manual labor. Collaborating with financial advisors who specialize in direct indexing solutions can provide critical investment management guidance, especially when navigating diverse or high-volume investment portfolios.

Their expertise can help you avoid unnecessary complexity and ensure your investments align with your specific investment objectives.

Transaction Costs

Transaction costs, like brokerage fees and bid-ask spreads, can get high fast in the world of direct indexing. If these costs aren’t mitigated, they can quickly chip away at returns. So, understanding the cost structures that are tied to your trades is key.

For instance, executing trades when overall market volatility is lower can reduce costs. By selecting brokers that provide customers with competitive pricing and/or zero-commission trades, the financial burden can be lessened substantially.

By considering these factors when you’re planning, you can help make sure that your strategy stays cost effective and in-line with your long-term goals.

Tracking Error

Tracking error is a typical risk measurement that quantifies how accurately a given portfolio mimics its benchmark’s performance. In direct indexing, for example, things such as market movements, rebalancing or tax loss harvesting can all lead to differences.

To prevent this from being an issue, prioritize diversification by sector and asset class while still tracking your desired index. Consistent performance reviews allow you to catch and fix any deviations, ensuring your portfolio remains in alignment.

Regulatory and Compliance

Steering through the regulatory waters Headed down the path of creating your own personalized ETF via direct indexing? Whether you’re an investor or an advisor, understanding the rules and compliance requirements ensures your portfolio remains aligned with legal standards and minimizes potential risks.

Understanding how these factors play a role is essential to earning public trust and ensuring long-term success with this transformative investment approach.

Understanding the Legal Framework

Direct indexing would work under a highly regulated environment that protects investor rights and fosters fair, orderly markets. For example, one regulatory framework – the Investment Advisers Act of 1940 – establishes fiduciary duties, requiring advisors to act in the best interest of their clients.

These rules directly shape decisions from portfolio tailoring to tax-slashing. Legal changes, like recent amendments from the SEC, can affect how portfolios must be managed, so it’s important to stay consistently abreast of developments to ensure compliance.

Reporting Requirements

Having accurate reports is critically important both for tax compliance purposes as well as for transparency. Investors would be required to keep extensive documentation on each trade, each dividend reinvestment, and every instance of tax-loss harvesting.

For instance, a mistake on their part when filing a tax-loss harvesting improper report could incur an IRS penalty. Robust reports help fulfill IRS due diligence requirements as well as build credibility and client-advisor confidence.

Luckily, transparency guarantees that clients will know what they’re being charged, which usually comes out to 0.20%-0.40% and would likely go down as account balances increase.

Ensuring Compliance

Staying in compliance is a proactive endeavor, requiring regular audits and input from compliance officers. These professionals help to ensure that regulatory standards are being followed, minimizing potential risks associated with non-compliance.

Further, firms like Schwab already reduce fees in line with account size – a move that helps ensure fairness and transparency. Educating ourselves on rule changes and performing self-audits strengthens our accountability to investors and protects their interests.

Future Trends in Direct Indexing

The world of direct indexing solutions, like all things tech, is quickly changing, driven by innovation and a growing desire for personalized indexing investors. As more investors seek bespoke portfolios, direct indexing is set to become a cornerstone of next-gen investment management, reshaping its future through emerging trends and adaptive strategies.

Innovation and Growth

Direct indexing strategies are expanding beyond traditional models, offering investors options to align portfolios with individual values, such as ESG (Environmental, Social, Governance) preferences. Fintech companies are further fueling this growth by creating platforms that make customization user-friendly and easier to adopt.

For example, tools enabling purposeful, real-time adjustments to portfolios in response to available market opportunities are rapidly increasing in sophistication and utilization. Attracting serious attention from industry experts, direct indexing is expected to experience strong adoption, particularly as the younger, tech-savvy investor demographic gains economic control.

You can finally escape the clutches of mutual funds and ETFs. Instead, on direct indexing you own the individual stocks that help you achieve your unique goals.

Increased Accessibility

Technological advancements are further dismantling those barriers. Today, retail investors can take advantage of direct indexing without the high price tag that historically prevented them from doing so. Platforms that provide access to fractional share investing and robo-advisors to recommend ETI portfolios are playing a key role in democratizing the process.

This trend is most significant to those with smaller portfolios who still desire more direct control over their investments. As new, simplified interfaces and lower fees continue luring investors of all types, widening the net of quality emerges within affordability.

The Role of AI

Artificial intelligence is revolutionizing the art and science of portfolio management, allowing for more intelligent, data-driven decisions than ever before. AI tools can pinpoint more tax-loss harvesting opportunities or optimize asset allocation with a greater level of precision, thus creating more alpha.

Through the analysis of enormous datasets, AI is able to predict market trends, allowing investors to get a leg up on the competition. These powerful, user-friendly capabilities maximize efficiency, agility and alignment to financial goals in every portfolio.

Conclusion

With these innovations, constructing a portfolio tailored to your personal goals and values is more attainable than ever. With direct indexing and bespoke ETFs at your disposal, you have the ability to approach investment decisions with incredible precision. They allow you to focus in on the opportunities, avoid doing the risk for you, and keep your money focused on what’s important to you. These options provide flexibility and then some—they provide control.

Together, the power of technology and customization changes everything about how you invest. It’s not enough to be reactionary and get ahead of the curve—it’s about understanding what strategies will help you succeed in the long run. Whether asset tax efficiency matters to you, certain industries matter to you, or customization/individuality matters to you, this method gives you control of that power.

Join the conversation, take the next step. Learn how direct indexing might open up new opportunities for your portfolio to thrive today.

Frequently Asked Questions

What is direct indexing?

Direct indexing is a personalized indexing strategy that allows you to invest directly in the individual stocks that comprise an index. Unlike traditional index funds or ETFs, this investing strategy offers greater control and customization, along with potential tax efficiencies that can enhance your investment portfolio.

How do bespoke ETFs differ from traditional ETFs?

Bespoke ETFs are custom-built to perfectly align with your investment objectives or values. Unlike traditional index funds, they offer a more personalized indexing experience, allowing for the exclusion of entire industries or targeting specific sectors.

Why should I customize my portfolio with direct indexing?

Customizing your portfolio through direct indexing solutions makes it easier to align your investments with your values, goals, and risk tolerance. It opens the door to more effective tax-loss harvesting as well as personalized indexing investors’ exposure to specific sectors or investment themes.

Can direct indexing help reduce my portfolio’s risk?

Yes. When customizing your investment portfolio using direct indexing solutions, you can reduce unwanted overexposure to risky sectors or companies while still achieving broad market exposure, enhancing your overall risk management.

What role does technology play in direct indexing?

Technology makes direct indexing easier by automating common factors such as stock selection, tax optimization, and portfolio construction. Advancements in technology have enhanced custom indexing solutions, making it more cost-efficient for personalized indexing investors.

Are there compliance concerns with direct indexing?

First and foremost, direct indexing needs to follow the financial regulations and rules of the road, which includes tax law and reporting requirements. Partnering with a financial consultant ensures that your personalized indexing portfolio is optimized towards your investment objectives while remaining compliant with regulations.

What’s the future of direct indexing?

Thanks to improved technology and a greater desire for personalization, direct indexing solutions are booming. This investment strategy will soon provide greater customization through advanced tools for personalized indexing portfolios, enhancing the investment management guidance available to investors.