(Forbes) In recent days several online brokerages have announced commission-free trades. That's great for investors, though there may be a few hidden drawbacks. However, more interesting is how the industry will continue to evolve in light of this. It seems that widespread commission-free trades could lead to broader adoption of direct indexing. This may hurt ETFs over the long-term as direct indexing services develop.
Today, direct indexing is a good idea in theory, but potentially costly in practice, typically that means that today it's an option for wealthier investors. Rather than say owning the S&P 500 via a low-cost ETF, why not own all 500 shares directly and rebalance them as needed? Well there are 500 reasons not to do that if you pay trading commissions, but if trades are free that’s no longer an issue.
Even if the costs are low, why would you want to avoid the convenience of an ETF and own shares directly? Well there are a couple of reasons. First off, we’re using the S&P 500 as an example, but say you work for Microsoft, well then you may already own a lot of Microsoft shares. Perhaps you want to own the rest of the S&P 500 but exclude Microsoft, but ETFs are one size fits all, making that impossible. With direct indexing you can create a custom allocation, or tweak an existing one, in a way that works for you.
Secondly, direct indexing may offer tax efficiency. Yes, ETFs can be tax efficient too, and indeed if you have an IRA or 401(k) then you have a way to defer the impact of any capital gains anyway. Still, if you’re in a taxable account, you can sell your losers and hold onto your winners and push your capital gains into the future, a technique called tax-loss harvesting. The more granular your portfolio is, which means the more individual holdings you have, the more opportunities are likely to present themselves. So direct indexing may offer tax benefits.
You can see where this is going. With some relatively simple trading processes, which can be delivered through software, you can build an ‘ETF-like’ vehicle that is custom for you and is potentially more efficient from a tax standpoint. Now with commission-free trading, that process of creating a 100 or 1,000 stock portfolio just became a lot less expensive to the mainstream investor. Indeed, some providers do offer direct indexing today, though primarily for wealthier clients. Furthermore, even though ETF fees are falling there doesn't' need to be any expense ratio with direct indexing. Yes, commission-free trading may come with higher implicit trading costs such as elevated bid/ask spreads. Nonetheless an unintended consequence of commission free trades is that now direct indexing is closer to reality for many small investors. How fast such services evolve and what the fully-loaded costs are remains to be seen, but the consequences for the ETF industry may not be positive, even as the costs of trading ETFs fall. Just as ETFs have seen rapid growth at the expense of mutual funds as a lower cost substitute, now direct indexing may take share from ETFs. The same drive for consumers to save money on their investments that boosted ETFs, could now spur the growth of direct indexing.