Direct Indexing As An Under-Tapped Wealth Management Differentiator 

The History And Benefits Of Direct Indexing, And How Technology Is Making It More Readily Available For Advisors
Mohan Naidu, CEO and Co-Founder, Alphathena
Mohan Naidu, CEO and Co-Founder, Alphathena

Direct indexing within separately managed accounts (SMAs) is now having a moment in the spotlight. After running below the wealth management industry’s radar for a few years, advisors should be ready to embrace the strategy as a differentiator for their clients and themselves. Yet, according to a report from Cerulli Associates, only 14% of advisors actively recommend direct indexing to their clients.

Simply put, direct indexing involves buying the individual securities within an index in the same weights – thus replicating the index, without needing to pay a third party to manage it as an ETF or mutual fund. The strategy offers the low costs, efficient upkeep and broad diversification of traditional mutual funds and ETFs, but permits advisors and their clients more control over the internal holdings of an index, giving them the ability to customize and personalize their investments.

In addition, holding individual securities directly in an index rather than in the corresponding ETF offers significant potential tax-loss harvesting benefits. This approach allows investors to selectively sell underperforming securities at a loss to offset gains, thereby reducing their taxable income.

Why Direct Indexing Took Time To Catch On

The idea of direct indexing isn’t new – it was proposed decades ago, but rarely implemented because it was expensive and time-consuming to trade so many individual stocks, and it was once nearly impossible to adopt outside of very large accounts. Technology has allowed the trading of fractional shares and zero-commission trading, removing one layer of barriers to direct indexing.

Direct indexing has historically been limited to institutions and the ultra-wealthy because the strategy was difficult to implement.

Direct indexing has also historically been limited to institutions and the ultra-wealthy because the strategy was difficult to implement. Research and other resources were needed to determine how much of each index component to buy or sell over time, and broad market indexes may have hundreds or thousands of components. Today, technology has removed those barriers as well.

The above-cited Cerulli report predicted that direct indexing would grow faster than ETFs, mutual funds and other separately managed accounts (SMAs) in the following five years, driven in part by advancing technology.

Why Its Time Has Come

Technology has made direct indexing more feasible – but why might an advisor want to offer direct indexing to their clients in the first place?

Portfolio customization. Investors clearly like the cost benefits and performance of ETFs and index mutual funds, but may feel disconnected from purely passive investments whose management is completely outsourced. Direct indexing within a separately managed account offers the ability to customize investments along a number of objectives and preferences, including:

  • Factor tilts: Direct indexing allows advisors to emphasize different investment factors, like value, quality, momentum or growth, efficiently over time using their own definitions of those factors.

  • ESG tilts: Advisors can easily apply positive ESG criteria to any index in the way that best serves their client’s interests.

  • Values tilts: Advisors can exclude or tilt away from securities that conflict with a client’s values. So if a client objects to companies that manufacture firearms, promote gambling or produce tobacco, direct indexing allows an advisor to customize a broad market index to reflect those objections. Advisors can also tilt towards securities that embrace their clients’ values.

Advisors are able to tailor client portfolios to their individual goals, interests, values and investment needs, offering an opportunity to deepen client engagement and enhance satisfaction. For clients with inheritances or equity compensation, advisors can also manage direct index strategies around large positions with a low cost basis.

Advisors are able to tailor client portfolios to their individual goals, interests, values and investment needs.

Advisors can also tailor direct indexing strategies to their own in-house management styles and philosophies.

Tax efficiency and optimization. Advisors can serve clients with proactive tax management within a direct indexing SMA by using tax-loss harvesting across an index’s individual components, allowing for more detailed tax optimization by offsetting their gains with strategic selling of losses.

Direct indexing also permits more tax-efficient transitioning of investments, offering advisors a chance to generate additional AUM and revenue by more easily moving assets with large capital gains in-house.

Transparency. Direct indexing permits clients full visibility into each holding within an index and the performance of each asset within their portfolio. Such transparency can help advisors build trust with their clients, and empowers clients by demystifying their investments.

Risk management and tracking error optimization. Just as it exists within ETFs and mutual funds, direct indexing strategies may experience some tracking error. However, today’s technology allows advisors to minimize tracking error to ensure that overall performance and risk levels are in-line with the client’s benchmarks. Now, portfolios can be automatically adjusted to stay within risk parameters established by the advisor.

Opportunity And Demand

Direct indexing allows advisors to provide investment options that go beyond what typical mutual funds or ETFs offer without increasing the cost to their clients. It presents a powerful opportunity to stand out in a crowded marketplace by offering an innovative, personalized investment solution attractive to discerning clients.

Thanks to technology, it’s easier now than ever before for wealth management firms to offer direct indexing to their clients. Furthermore, over time the benefits of direct indexing, like tax optimization, investment customization and personalized services, are being demanded by clients.

Over time the benefits of direct indexing are being demanded by clients.

Our platform, for example, uses artificial intelligence to remove much of the workload associated with managing highly customized portfolios. Our direct indexing tools also integrate into advisors’ existing systems, enhancing workflows and increasing efficiency to allow more time for client interaction and strategic advising and less time on back-end management.

Mohan Naidu is Co-Founder and CEO of Alphathena, a provider of customized indexes, tax optimization and account management for financial advisors.

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