Is direct indexing more Mustachian than ETFs?

Has anybody considered direct indexing instead of ETFs?

ETFs are not free, even if fees are low nowadays. But to keep the fees low, many ETFs take risks by lending stocks to third parties. If there is a crash it could backfire. ETFs are also exposed to market liquidity risks. And in case an ETF issuer bankrupts, it will cause a lof of paperwork headache for just one, big concentrated position in the portfolio that will remain blocked for a while.

I also saw claims that the diversification benefit reached with 30 stocks is not much lower than having the whole market, and there are brokers who have very low fees for stock transactions.

Is there anybody here who directly owns stocks and who could share their experience?

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Yes, that’s an interesting strategy, but how would you select the 30 stocks?

It is true that the law of diminishing returns kicks in at around 20-40 stocks and therefore the diversification effect is much lower and becomes negligible at some point.

However, stock market returns are not normally distributed and the vast majority of alpha is generated by very few stocks. Basically you would have to find and pick the outliers and a random sampling strategy wouldn’t probably be as effective as the overall market. So you would basically need something like a quantitative model that is able to predict the outliers and/or get rid of the ones with likely negative returns. Doing manual research on hundreds of stocks is unfortunately not an option for most people due to time constraints.

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I have considered.

  1. Costs for rebalancing >100 stocks every 3 months or so are prohibiting.

  2. Try to replicate a market weighted index/ETF such as VT with your portfolio size. Let’s say you define minimum position size is 1000 USD. How many positions can you hold? 20? 50? But biggest chances are coming from mid and low caps.

So you can create your own equal weighted portfolio of Swiss cantonal bank stocks or replicate Stoxx Europe 600 Insurances Index, but nothing more complicated.

This is about correlations, not about returns.

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I suppose you would select the stocks the same way an ETF does. That is, you buy the stocks tracked by an index, as per the index weighting. For long-term investment, this can save a lot of money over paying a fund manager to invest for you. The downside is that you need to put in the time to monitor the index and remove and add stocks as they are removed and added from the index.

It is important to consider the cost of brokerage fees. Generally the shorter-term the investment, the more expensive the (high) one-time stock brokerage fees are compared to the (low) ongoing ETF fees. But the longer you hold the investment, the more expensive ETF costs become in relation to brokerage fees.

If you are investing for the long-term and are willing to put in a little more work, there really isn’t any advantage to using index ETFs instead of buying the stocks making up an index directly. ETFs are only about convenience, just like asset management services. If you are willing to pay for convenience, than ETFs are a good option.

While the costs of many ETFs are low, even low costs can add up over time. For example, if you used an index ETF with a 0.20% TER to invest 100,000 francs for 30 years, you would pay 5824 francs to the fund managers in fees. If you paid a brokerage fee of 10 francs when you buy the ETF shares, which is a best-case scenario, you would have a total investment cost of 5834 francs.

If you invested the same 100,000 into 40 stocks making up an index for 30 years, you would pay a 10 franc brokerage fee per position, or 400 francs. Assuming you need to sell one stock and buy one stock every 10 years as companies on the index are swapped, that would add another 60 francs. So your investment costs would be 460 francs in total.

So direct investment would cost you 5374 francs less than using an ETF, in this case.

Feel free to tinker around with this calculator:

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Remember that there is constand share re-purchase, funding and changes to free-float. Meaning that if you want to somewhat stay close to Index fund weighting, you will incur significantly more transactions than just one swap every 10 years… The question of course is what difference actually translates to materially different return - but I don’t want to do optimiuzed sampling myself but leave this to the experts.

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it depends on how to define Mustachian :smiley: mustachianism is about automation and simplification as well. If you mean cheaper, maybe (not sure it depends how much you rebalance). If you mean freeing up mental space for doing other things (which is the core of becoming FIRE) then probably not.

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No only that… You get worse conditions - costlier transactions, worse currency conversion etc… They can do that on an institutional level. That combined with the fact that VT costs like 0.07% p. a. for 9K stocks is unbeatable imho.

And as stated: You eliminate the correlation with 30-40 stocks over the sectors, but you can’t guarantee that you own all of the alpha stocks or even just a part of them (maybe more, maybe less - probably boath over long time periods). Maybe you only own all of the 2nd and 3rd tier stocks for a sector etc…

There is much more factors to that and the question is would you really outperform the index? And if yes: By how much? If you factor in the work: (Buying, rebalancing, filing taxes for 40 instead of 1-5 ETFs or so)… You are basically playing a game you can’t win.

If fees were 1% sure… But with fees <0.1% not worth it imho.

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… not to forget reinvesting dividends… and withholding taxes of foreign stocks (from outside of NA)… would make this a fool‘s errand.

In my opinion, individual stocks are an option only for specific bets or if one considers their management a hobby. Otherwise it is not worth one‘s while, especially since etfs have become quite cheap… (highly diversified portfolio with TER below 0.1 % is feasible).

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I agree that for highly-diversified portfolios with hundreds or thousands of different stocks, it’s impossible to beat the best-priced ETFs (i.e. VT ETFs) as a small/private investor. But if, for example, you’re looking to replicate the SMI with its 20 companies and pretty infrequent rebalancing, that could be done cost-effectively through direct stock investment.

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A SMI ETF is probably in the same price range with VT. I hold CHSPI which has 200+ holdings and costs 0.1% TER… That combined with all the other work makes this really unattractive imho.

An ETF or a mutual fund are the best vehicle to replicate or come as close as possible to an index. Sure you might do your SMI magic, but then those dividends need to be reinvested etc… I guess above a million or so (in only Swiss stocks) that would make for a little profit while providing a lot of work when filing taxes.

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The tax hassles are certainly a good argument for ETFs. I was approaching it strictly from a cost perspective.

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I’ve been entertaining the idea for some time and am now dabbling in some form of it. The idea, for me, is to practice some kind of activism with my investments (no matter how small my stake in the companies I invest in is) and exert my voting rights in general assemblies. To me, that means investing in swiss stocks (for proximity) and picking the companies I want to invest in, so no real indexing.

I’m adding a component of stock picking/value investing/market timing, the idea for me being to invest in companies with good prospects, to gradually increase my share in them and never sell them until I need the money so rebalancing isn’t a factor in my decision, which makes it easier.

The advantages for me, for someone investing in swiss stocks, are:

  • A better grasp on what companies I invest in (I can weed out the ones with which philosophy I don’t align).

  • More leeway in the percentage a single company takes in my portfolio (no Nestlé, Roche, Novartis at near 20% in SMI or SPI investing).

  • No extra fees for a service I don’t feel I really need (a few stocks make the vast majority of the weight in the SMI/SPI/SLI, so it’s easy to pick a similar degree of diversification without resorting to indexing + I don’t feel frequent rebalancing plays such a huge role at this level (I may be wrong and haven’t searched for studies on the matter)).

  • I get the full benefits of my shares, including voting rights (which comes at a cost because being on the shareholder register crosses out the cheapest brokers but I personally deem it worth it).

For broader investments in foreign markets, I’d resort to indexing and ETFs for diversification and because I’d be too small a fish to expect being made whole if I got screwed in any way, while mega funds providers have much more leverage to protect my interests.

The way I see it all may evolve with time and I may get convinced by broadly diversified index investing at a later stage, or not.

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It never stops surprising me how much savers (I assume you are in the wealth accumulation phase) waste time on all sort of activities. Pick one of the well-known ETFs (I suggest ONE) and then mainly focus on increasing your salary until your annual investment gains are above your annual investment savings. Focus on the things that REALLY move the needle.

Maybe reading the first sections of “just keep buying” (recent book) helps you.

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Some people waste their time going to the theater, some do it picking stocks. Some people waste it going into politics, some voting at private companies general assemblies rather than letting that power getting concentrated in the hands of funds management firms. Yes, the saving rate moves the needle more and increasing our salary has more of an impact on our financial situation but not all reasons behind the choice of an investment style are financial. :wink:

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The 5824 CHF is a massive underestimate. Note that the 100000 is growing so the amount lost keeps increasing. The cost over 30 years should be around 10000* ((1.075)^30 - (1.075-0.002)^30) = 47569 CHF, where I assumed a 7.5% return. Perhaps this is too optimistic but even at 5% per year it should be 24026 CHF. A much more substantial sum. (Or is this wrong? Am I misunderstanding the TER?)

I have been thinking about this myself. I diversify through ETFs because I think it is a cheap way to minimize variance at only a small price to the expected value. But I don’t believe minimizing the variance should come above all else as some other people on here do. Expected value counts too. To me it is not that important that I’m perfectly diversified as long as I’m at least somewhat diversified.

So for me having the majority of my savings diversified through ETFs is enough for me to try to avoid some TER fees with a smaller portion by adding some stocks one by one. Note that this is just as lazy and no more time consuming than buying the ETF (I buy once and hold, I don’t rebalance).

(This also allows me to pursue a better dividend strategy for my tax residence (France) since I can pick only stocks that don’t give a dividend. Yes growth-over-dividend is another bias, but since it is not clear in what direction it really doesn’t matter much.)

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this was more directed at direct indexing - but at least good to be fully aware of this fallacy (I waste my time here on some kind of hobby and don’t change the trajectory of my financial independence). In fact, I would argue by going after individual stocks you even run the risk of delaying your fire date (picking wrong stocks, panicking etc).

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You are not wrong. Let’s say you have 1 000 000 already and you don’t want to touch them for next 20 years. You can invest this amount once in all 1500 components of MSCI World according to the index proportion and only collect dividends, occasionally replacing components. In this case you are better off with a direct indexing. But if your portfolio is 50k and you add 500 every month, you can’t do it. Rebalancing will be too expensive. And you don’t have enough wealth to buy all components, so your tracking error is significant.

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direct indexing is a thing for the us where some wealth robots do it for you behind the scenes. the idea behind is that this allows you to do tax loss harvesting (applies mainly to the us) and/or to remove a stock that you are already extremely exposed to (for example your employer). but again, for most folks here this is at this point of their life a huge waste of energy.

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The majority of the stocks in the MSCI world has a weight below 0.3%. Good luck trying replicating the index with direct lines, as well as following the entries and exits in the index.

It would cost more than an ETF fees. ETF would have the critical mass to benefit from the double tax treaties → reduced tax rates on dividends.

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And what if you’re at the point were you already reached the salary cap in your area and potential further promotions are very unlikely to happen without pursuing a management career?

I don’t think I can increase my salary any further and even now many companies are unwilling to match that salary. Not everyone is a software engineer who works for (and/or is willing to work for) a FAANG company or crypto start-up that would pay significantly more.

I could work as a freelancer and do some sorts of side hustles to increase my salary but I’m also a person who appreciates a decent work-life balance. I could imagine doing a side project if it would be really fun for me to do and doesn’t feel like work but I didn’t have a realistic idea so far :slight_smile: Any tipps are very welcome :slight_smile:

I don’t think the goal of most stock portfolios is to replicate a certain index by allocating stocks as per market weight - this is more common for indices and funds. I think with a 20-40 stocks portfolio an equal weight strategy is more common, but I’m not a portfolio manager so I can’t be sure, it’s just what I heard :slight_smile:

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