Direct Indexing offers investors three key benefits versus ETFs and Mutual Funds:

Tax Alpha

Tax alpha has been estimated to add between 1.5 and 2% in additional after-tax returns for a typical US high-tax bracket investor. Direct Indexing gives the investor a choice around what stocks to hold and what to sell. This flexibility permits the investor to utilize well known tax- management practices.


Direct indexing makes it possible for an investor to fine-tune, or more broadly alter, the individual stock constituents of an index.

SRI considerations have advanced to the top of many investors’ agendas. Through Direct Indexing, the investor can adapt an index based on specific, investor-determined environmental, social or governance policies.

In a nutshell, instead of buying an off-the-shelf ETF, or even an SRI-based ETF, Optimal can apply screens specified by the investor. We can also add individualized screens such as filtering out legacy holdings, or faith-based preferences such as Shariah compliance.

For instance, an endowment or family office may wish to exclude companies suffering from low scores on labor practices (e.g. as a result of child labor or human rights violations). SRI ETFs that are available to the investor are standardized to predefined policies and screening rules, and it is likely the investor would have no ETF option available that would be so specific to this labor-based exclusion.

Additionally, an investor could add an exclusion to avoid adding to an existing position that the investor already holds elsewhere in their portfolio (a legacy position). Consider an investor wishing to add an allocation of S&P 500 stocks. As a result of long-held legacy positions, this investor holds several stocks not prudent to sell, due to the large embedded capital gain liability. These stocks could therefore be excluded from the SMA portfolio to avoid adding to the stock-specific risk of these holdings.

Again, investing directly in the stock portfolio offers solutions otherwise unavailable in an ETF.

Going Bespoke

ETFs have revolutionized the way by which retail investors gain access to the market. More than 25 years after their launch in 1993, they remain one of the most efficient pooled investment vehicles available to retail investors. Additionally, most ETFs offer more favorable tax treatment than Mutual Funds.

In situations where an ETF already exists that meets the investor’s objectives, is liquid, low-cost, well-run, has long term viability and is available from a well-established ETF provider, that ETF is almost always the most cost-effective and efficient option.

However, in other situations, ETFs are not always a viable option.

In fact, many excellent indices are simply not available in a pooled wrapper. The Index Mutual Fund and ETF marketplace is tailored for indices with mass retail appeal. As a result, only a small percentage of the indices produced by index providers are available as ETFs. Direct Indexing can be utilized to deploy indices for which no suitable ETF currently exists.

Direct Indexing can go beyond customization screens, and be used to create bespoke strategies that are precisely tailored to the investor’s needs, such as S&P 500 Ex Low-Vol, or “narrow optimization” such as an eighty stock version of a much broader index.

Precision factor indices from providers such as S&P Dow Jones Indices® can also be used to build custom drop-in replacements for Mutual Funds and Active Management.

Delivered as SMAs, these fully bespoke strategies are designed in conjunction with investment advice from Optimal as needed. They are built as a combination of indices and sophisticated optimization techniques (such as Risk Parity, Max Sharpe Ratio) and can replace quant strategies without requiring an in-house quant team or an expensive active manager.

Modern investment tools such as Optimal’s Factor AllocatorTM have made the creation of individualized index implementations “push-button” easy for advisors and institutions wishing to exercise greater control over the index investment process without having to resort to expensive actively managed solutions.