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.