The Pros and Cons of Personalized Indexing
Investing in a fund that tracks a broad market index—such as an exchange-traded fund (ETF) or a mutual fund—is a simple, cost-effective way to participate in the market. That said, the average investor has been powerless to adjust an index's underlying holdings to reflect their individual circumstances or goals—until now.
Enter personalized indexing, which adds a degree of customization to the broad market exposure of index investing. Here's how it works.
Lower-cost customization
Traditional index investing means buying a passive fund that seeks to track, rather than outperform, its benchmark index. Direct indexing, in contrast, involves buying most (if not all) of the individual stocks that make up an index, and then adding to, subtracting from, or reweighting its components, depending on your investing and tax goals. This gives you more control over your investment.
As you can imagine, the cost of replicating all the securities in a benchmark index—to say nothing of the associated management and trading fees—would be cost prohibitive for most investors, which is why direct indexing was previously available only to ultra-high-net-worth investors. However, the rise of zero-commission trading, as well as advances in technology, have made it possible for investment firms—including Schwab—to offer direct indexing products at a much lower cost.
The pros
There are several key advantages to customizing an existing index:
- Potentially boost after-tax returns: When you invest in an index mutual fund, you're subject to regular taxable distributions—even if you don't sell any shares—because mutual funds are required to distribute to shareholders any capital gains that were realized as a result of selling their underlying holdings. When you directly own the individual securities of an index, you control when shares are sold and thus when capital gains (or losses) are incurred, allowing you to better manage your tax liability—particularly when you have significant gains that could trigger a hefty tax bill. In such cases, you can choose to strategically sell some of your losers to offset those gains, a strategy known as tax-loss harvesting.
- Help reduce concentration risk: If you own substantial shares in a company that also represents a significant portion of an index, adding that index to your portfolio could create a concentration risk. For example, let's say you own $10,000 of Apple stock and want to invest an additional $90,000 in an index fund that tracks the Schwab 1000®. In mid-March 2023, Apple made up roughly 5.9% of the Schwab 1000, meaning your Apple exposure would rise to 15.3%. Personalized indexing would allow you to exclude Apple and keep your exposure to that stock at 10% of your overall portfolio.
- Better align your portfolio with your values: With a traditional index fund, there's no way to avoid industries that may be at odds with your goals or personal beliefs, such as gambling or tobacco. You can opt for a socially conscious fund, of which there are many, but you still have no control over the individual companies in which it invests. With personalized indexing, you can make exclusions within certain parameters. At Schwab, for example, you can exclude individual stocks as well as entire industries and sub-industries.
The cons
There are some trade-offs with investing this way, namely:
- Higher costs: Expect to pay a management fee of anywhere from 0.30% to 0.40% for a personalized indexing solution, versus 0.20%, on average, for a traditional index fund.
- Higher minimums: Unlike index funds, many of which can be purchased for less than $50 a share, you'll likely need tens if not hundreds of thousands of dollars to invest in a personalized index strategy.
- Administrative burden: The downside to owning hundreds of individual stocks is that each will have its own cost basis, dividends, and profit and loss, which could become burdensome at tax time. Investors may have to report each transaction individually on their tax returns if their brokerage firms do not provide consolidated 1099 tax statements, or if their tax-preparation software does not accurately read the statements.
The upshot
Ultimately, personalized indexing makes the most sense for investors in high tax brackets who want to take advantage of tax-optimization opportunities, as well as experienced investors who want more customization than they can get from a traditional index fund.
Schwab Personalized Indexing™
Designed to be a core component of your investments, Schwab Personalized Indexing offers four strategies based on established equity indexes:
- Schwab 1000 Equity: Designed to provide access to the 1,000 largest U.S. companies, covering approximately 90% of total U.S. stock market capitalization.
- S&P SmallCap 600®: Designed to track 600 companies in the small-cap segment of the U.S. equity market.
- MSCI KLD 400 Social: Designed to offer exposure to companies with outstanding environmental, social, and governance (ESG) ratings and excludes companies whose performance has had negative social or environmental impacts.
- MSCI EAFE International: Designed to represent the performance of the large- and mid-cap segment across developed markets1 around the world, including countries in Europe, Australasia, and the Far East but excluding the U.S. and Canada.
You can personalize your chosen strategy by excluding individual stocks or even entire industries or sub-industries. The process is guided by our proprietary tool to help ensure that your strategy will still track its reference index.
1While this strategy seeks to track the performance of and mimic characteristics of the MSCI EAFE Index, it will not invest directly in the local securities tracked by the index. It will invest primarily in American Depositary Receipts (ADRs) and equity securities of MSCI EAFE Index issuers that are traded on U.S. stock exchanges which may not align to the index exposure of every country at all times.
An index-based portfolio customized by you
To learn more, visit Schwab Personalized Indexing or call your Schwab financial consultant.