The second part of the analysis explores how to integrate direct indexing into an existing portfolio through the lens of the Vanguard Asset Allocation Model (VAAM). From an asset allocation perspective, the implication for direct indexing and personalization for high-alpha investors, such as Investor B, is straightforward. The pursuit of personalization may result in greater tracking error against the benchmark, but the optimal allocation and expected risk–return profile of the entire portfolio will remain largely unaffected.
“For high-alpha investors, the optimal allocation to equity effectively equals the allocation to direct indexing at all reasonable levels of tracking error,” Khang said. “So, our asset allocation recommendation is easy: Replace the equity allocation to passive taxable U.S. equity with direct indexing and personalize freely.”
But for low-alpha investors, such as Investor A, greater personalization has important performance and implementation implications, Khang said. Greater tracking error in direct indexing, he said, calls for a lower allocation to equity and therefore a lower expected return from the entire portfolio. As tracking error rises above 75 bps and optimal equity allocation declines, the optimal mix between direct indexing and passive equity may also change.
“Low-alpha investors may want to lower their overall equity allocation to accommodate meaningful personalization in their portfolios,” he said.
Khang said the paper marks an important development in direct indexing. Until now, the marketplace for direct indexing lacked general guidance on implementing it in a portfolio.
Although investors still need to customize their portfolio plans to determine the optimal allocation to it, Khang said, “our research presents an evidence-based starting point that investors can use for adding direct indexing to their portfolios.”