With direct indexing set to grow at a 12% annualized rate, advisors can use these investments to assist clients with taxes, but tech advances offer other significant advantages.
According to research firm Cerulli Associates, direct indexing is poised for growth, with assets expected to reach $800 billion by 2026[1]. The investment vehicle is also becoming popular with financial advisors who can customize an index – improving tax harvesting value and tailoring investment exposures.
With direct indexing, advisors can create a personal basket of stocks to track the return of a target index such as the S&P 500. This customized basket lets advisors sell individual holdings rather than the entire index, which is needed if the client only owns an exchange-traded fund or mutual fund. This tax-loss harvesting flexibility is the biggest selling point for this investment vehicle.
The hidden advantage of direct indexing, however, is even more powerful than its tax efficiency for certain clients: the technology that makes direct indexing possible at scale also optimizes portfolio constituents.
Advisors can now personalize indexes for clients with significant holdings of company stock, reducing a client’s overexposure to a specific holding. For clients who steer away from certain companies or industries, direct indexing can finely tune holdings versus comparable ETFs or mutual funds. It also makes charitable giving more efficient.
New Technology Breathes Life into an Old Strategy
Direct indexing makes the concept of separately managed accounts traditionally found at the institutional level available to many more clients and allows advisors to offer it at scale. Deloitte finds robust algorithmic trading technology, low trading fees, and the advent of fractional shares lowered direct indexing’s cost[2].
Cerulli’s $800 billion growth estimate for direct indexing by 2026 reflects that the investment vehicle will grow at an annualized rate of over 12%[3]. That’s a faster growth rate than the expected growth of mutual funds, exchange-traded funds, and separate accounts. In addition, Cerulli cites the tax efficiency and other advantages for the potential growth.
Hidden Advantages
Tax-loss harvesting grabs all the headlines because the algorithm does the work for the advisor; taking advantage of losses anytime during the year automatically. However, the algorithm’s hidden advantage is how it optimizes holdings.
Direct indexing’s optimization can mimic index-like returns for investors even if they don’t own every index component, according to Barron's[4]. For example, the article explains if a client is a Microsoft employee and owns company shares, simply owning the S&P 500 exposes the client to concentration risk. With direct indexing, the algorithm does not simply swap out Microsoft for IBM; it efficiently finds stocks in other industries with similar return patterns to Microsoft.
Barron’s also notes direct indexing does not have to be a whole portfolio solution. Instead, direct indexing can be a complementary part of a household’s portfolio as it can generate losses that can offset gains in other parts of the portfolio.
The Cerulli research points out that direct indexing’s portfolio optimization can assist advisors who engage with ESG and values-based clients. For example, direct indexing can be used to screen not only for environmental-based criteria but also for social factors or religious values. In addition, personalizing portfolios to align with values while tracking certain index characteristics returns allows advisors to deliver tangible service beyond investment returns. The market research group says direct indexing may also open up advisors to work with endowments, foundations, and other long-term investing pools, which need to ensure their investments reflect their mission.
Direct indexing also offers advisors the ability to customize an index that may have a tilt to a specific sector, style, or market cap weighting. This allows the investor to express a certain investment view, and the advisor can automate that portfolio tilt rather than doing so manually.
Enhanced Charitable Giving
Direct indexing can be pursued as part of a long-term goal to take full advantage of the tax-loss harvesting capabilities. Over time, as poorer-performing stocks are sold, a portfolio’s cost basis may rise. That opens another avenue for advisors to deliver value to charitably minded clients.
Often, clients donate highly appreciated securities directly to a charity or as part of a donor-advised fund. Cerulli explains when advisors approach direct indexing and charitable giving as part of holistic wealth management, advisors can automate and optimize the process throughout the year to take advantage of market fluctuations.
Using Direct Indexing Technology to Augment Business
The personalization trend seen in other parts of our lives is now available for investments. Direct indexing allows advisors to balance customizing a portfolio to a client’s objectives while maintaining some return predictability by tracking an index. As a result, advisors have the opportunity to re-think their value propositions and service models and take advantage of new technologies to deliver differentiated offerings and a more personalized client experience.
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[1] The Case for Direct Indexing: Differentiation in a Competitive Marketplace, Cerulli Associates, December 1, 2022
[2] Next on the horizon: Direct Indexing, Deloitte
[3] The Case for Direct Indexing: Differentiation in a Competitive Marketplace, Cerulli Associates, December 1, 2022
[4] Direct Indexing Is Taking Off. Is It Really Better Than an ETF?, Barron’s, December 14, 2022
