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How to Talk About the Customization Benefits of Direct Indexing

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Natalie Miller, CFA

Director, Investment Strategy

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Best known for tax management, direct indexing can do so much more. Despite the potential benefits a customized portfolio can offer, many advisors find the topic difficult to discuss with their clients. Yet that important conversation can be surprisingly simple to initiate.

Many investors are familiar with the tax-management capabilities of direct indexing: providing broad market exposure, transitions out of concentrated positions, gifting strategies and so on—all with tax efficiency. Reducing taxes is certainly a benefit that can be easy to quantify, which helps to make it easier to talk about with clients. 

Advisors tend to avoid talking about the other potential benefits of custom separately managed accounts (SMAs). Perhaps they lack knowledge of those benefits, or they may hesitate to bring up an area of portfolio management that can be harder to calculate.

In addition to tax management, portfolio customizations can take many forms and may produce many benefits. Let’s discuss how advisors might raise the subject.

Customization benefits beyond tax efficiency

Incorporate client-specific values

Investors come in all shapes and sizes, with varying backgrounds, wants and needs. Shouldn’t their portfolios attempt to reflect their individuality and values? For some advisors—and their clients—this may sound too touchy-feely. Using terms like personalization or customization can help remove that emotional aspect. 

Investors can now personalize many aspects of their lives, from how they order coffee to how they consume news. Either they already expect that kind of personalization in their investment portfolios, or they’ll be really glad when their advisor brings it up. Discussing personalization in this way shows that you really know your clients; they’ve entrusted you with knowledge of what’s important to them.

Define a client’s own passive market exposure

Not every investor needs or wants the S&P 500® as a passive large-cap equity exposure. Maybe a client wants or needs a different slice of the market. 

Perhaps they work at a tech company or hold a large position in an energy stock, so they want to restrict a particular sector or industry. Or the client could be looking beyond US large-cap to customize or overweight their small-cap exposure, or to broaden their domestic holdings to incorporate international exposure.

Many investors could benefit from the ability to optimize the index to suit their own needs, rather than buying a single basket of securities in a single transaction through a commingled fund. Advisors can use the index as a starting point, not as the final destination.

Express a client’s active market views

What if a client feels strongly that a particular industry or sector is poised to perform better or worse than the market? If they expect underperformance, they could construct a portfolio of sector-specific ETFs, excluding the one they don’t want.

That may sound simple but think of the complexity in managing such a portfolio—rebalancing while avoiding overlaps in that combination of sector ETFs. In a custom SMA portfolio, the client—not some ETF or index provider—could be able to say exactly which securities should be emphasized or de-emphasized.

What if their views change? Buying and selling ETF portfolios can be cumbersome and may lead to tax consequences. With a custom SMA, it’s generally much simpler to adjust their instructions to the SMA provider.

Help clients get the precise exposure they seek

Fully delivering on that customization

Approach the conversation with clients

To start the conversation, all you have to do is ask. Ask clients if they would be interested in a portfolio customized to their needs and goals. And if taxes are important to them, this portfolio could also allow them to save taxes on their gains. These conversations can be free from emotion and may serve as a way for advisors to demonstrate that they really know their clients.

When discussing customization benefits, advisors should make sure their clients know that someone else will do the work. They don’t have to take their own time or resources to research stocks themselves.

For example, if they don’t want to invest in companies that use child labor, they can discuss this with their advisor—identifying and clarifying their preferences—then let the advisor take it from there. The advisor can work with a custom SMA partner who does have the resources to know which companies the client might choose to exclude. 

Set expectations

Conversations between advisors and their clients should set expectations around performance, including potential deviations from the benchmark. Emphasize that an investor can’t try to beat the benchmark—pretax or after tax—and also be the benchmark—that is, get the exact same pretax return.

Holding a different set of securities may be essential to facilitating the investor’s goals, but such a portfolio has the potential to outperform or underperform the benchmark. Tracking error is one way to measure that.

Keep the discussion alive

Collaborating with the client doesn’t end when the advisor has determined the right portfolio; reporting is a critical next step. Show the portfolio’s characteristics and sector exposures while demonstrating how it incorporates their needs and wants. If the portfolio is geared toward managing for taxes, show after-tax performance.

Consider creative and tangible ways to demonstrate the impact the portfolio has in real terms and how it may have changed over time. An ongoing discussion of a client’s wants and needs can help cement the value advisors bring.

Avoid getting bogged down by details

Personalization brings complexity, but the advisor doesn’t have to do the heavy lifting of stock research or portfolio optimization in the face of security restrictions. Work with an SMA provider who has the expertise and experience to make that part of the job easy, so the advisor can focus on building relationships with clients.

The bottom line

Beyond tax management, as important as that is, direct indexing can be a powerful tool to provide efficient customization of client portfolios. Discussions about customization benefits can be a natural extension of the connecting conversations advisors already have with their clients. What’s most important to the client will drive the ultimate solution. It doesn’t have to be an uncomfortable conversation to determine the path to that end.

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