International Securities in Direct Indexing: Considerations and Costs

As investors seek more personalized investment strategies, direct indexing continues to gain traction. Direct indexing is a customizable and tax-efficient alternative to investing in traditional mutual funds or exchange-traded funds (ETFs). By allowing investors to directly own the individual securities comprising a market index, it offers tailored exposure and potential tax loss harvesting benefits. However, when the index includes international securities, this approach presents unique challenges and costs. This article delves into these considerations, offering insights for financial advisors and investors in the realm of direct indexing.

Challenges with International Securities

– Trading Complexity

Trading international securities introduces several complexities not typically found with domestic securities. Different time zones, varying market holidays, diverse regulatory environments, and currency considerations all contribute to the complexity. Stock exchanges worldwide operate on different schedules, which can affect trading hours and settlement times for international securities. Moreover, due to less predictable fill rates and price movements, obtaining the desired number of shares at expected prices can be challenging, potentially affecting the overall portfolio strategy.

– Higher Trading Costs

The cost of trading international securities often exceeds that of domestic trades. Brokerage fees, currency conversion charges, and potential tariffs add layers of expense. Custodians typically charge higher fees for international transactions, citing additional complexities and operational costs.
Manual trading desks can also get involved—especially when basket trades need to be split across multiple markets or when liquidity is low—further increasing the cost. For this reason, direct indexing with a significant international exposure generally requires a higher level of capital to accommodate these additional costs efficiently.

Strategic Approaches to Balancing Costs and Complexity

– Use of ETFs for Exposure

One common strategy to mitigate these challenges is to combine direct indexing with international ETFs. While direct indexing provides customization and tax-loss harvesting opportunities through domestic stocks, ETFs can supply international exposure cost-effectively. By investing in a combination of ETFs and individual domestic securities, investors can capture both foreign and domestic exposure without incurring the full brunt of the complexities and costs accompanying direct international trades.

– Subset of World Indexes

Investors can also consider utilizing a cost-effective subset of world indexes. Creating a basket of essential international stocks to replicate world index performance can offer a balanced global exposure with manageable costs. This selective engagement allows an investor to benefit from direct indexing’s customization and target tax loss harvesting opportunities while sidestepping the substantial fees and complexity of transacting in less accessible markets.

Real-World Example

Consider an investor looking to replicate the MSCI EAFE Index, known for its broad exposure to developed-market international securities. Instead of directly owning all its constituents, which include over 800 stocks from 21 countries with differing market conditions, the investor might select a representative sample that mirrors the index’s geographical allocation and industrial sectors. By integrating targeted international ETFs alongside their selected securities, the investor effectively manages costs while still capturing the desired exposure.
Additionally, a portion of their investment can remain in domestic securities where they can fully leverage direct indexing’s benefits, such as tax-loss harvesting and personal investment values customization, with minimal additional cost or complexity.

Conclusion

The allure of direct indexing lies in its ability to offer taxes-efficient customization and diversified exposure. However, when extending this strategy to include international securities, investors and financial advisors must navigate a complex web of market conditions, operational considerations, and elevated trading costs. By strategically blending direct indexing with international ETFs or creating manageable subsets of world indexes, investors can still achieve their desired global exposure with greater control over costs.