Your clients may be curious about direct indexing. Do you know what to tell them? Keep in mind that tax management isn’t the only reason for advisors to recommend direct indexing. A new report from Cerulli Associates finds more.
According to a December 2022 report from Cerulli Associates, assets in direct indexing are expected to grow 12.3% annually over the next five years, outpacing the growth in ETFs and mutual funds. An increase in publicity and the number of direct indexing providers should lead to higher awareness among advisors and investors. Currently only 14% of advisors are aware of and recommend direct indexing to their clients, even as 63% of advisors serve clients with more than $500,000—an account size that could best benefit from all direct indexing has to offer.
From active tax management to customized responsible investing rules, direct indexing delivers multiple sources of differentiation to advisors. It helps them give their clients the flexibility to create portfolios just right for their unique goals and values. But why aren’t more advisors using it? Perhaps advisors don’t know which clients might benefit from direct indexing—or they don’t know how to talk about it. After more than 30 years of experience in the direct indexing space, we can give advisors a tip or two.
Which investors benefit from direct indexing?
According to advisors, the most common benefit of direct indexing is improved tax efficiency. Clients understand that it’s not what they make—it’s what they keep. Managing tax losses and gains throughout the year at an individual security level is one of the most talked-about features of direct indexing. A client who requires tax losses to offset gains elsewhere in their portfolio could find direct indexing especially valuable. But tax-loss harvesting is far from the only value add of direct indexing. Here are some other use cases:
Forming the core of a core-satellite portfolio. Depending on how the client wants to define the market, advisors can use a single benchmark or a blend of benchmarks to build a tax-efficient core exposure, with satellite allocations to active managers or tactical positions making the total portfolio. Investors can use tax losses harvested in the core to offset gains from the more tax-inefficient satellite sleeves. But this isn’t to say that investors can apply direct indexing only to their core holdings. They can also use the strategy to get tax-efficient exposure to satellite-friendly asset classes, like international and small-cap equities.
Creating client-specific environmental, social, and governance (ESG) guidelines. Direct indexing works exceedingly well when it comes to tailoring portfolios to reflect clients’ unique ESG principles. Advisors can make this happen using a variety of methods, from screening out objectionable industries to filing shareholder resolutions. Direct indexing gives advisors and investors more control over the securities they hold than an ETF or mutual fund can give.
Diversifying around or out of concentrated positions. Direct indexing helps clients manage and unwind their overweights through tax-loss harvesting, planned charitable giving, and tax-efficient withdrawal techniques. This may be the first task that a new client sets for their advisor. Having the tools to solve complex client problems like this is the best way for an advisor to attract more business and deepen their existing relationships.
Planning tax-efficient charitable donations. Donating highly appreciated securities to charity means the investor avoids the tax liability of the gains embedded in the security. Replacing the highly appreciated securities with new cash also resets the portfolio’s cost basis, creating the potential for tax-loss harvesting opportunities in the future.
Building laddered fixed income exposure. Direct indexing can play an important role in the fixed income space as well as equities. A laddered bond strategy provides a similar level of control over bond holdings, giving investors the flexibility to realize losses while sticking to their desired maturity, credit quality, and geography characteristics.
How should advisors discuss direct indexing with clients?
Investors may be curious about direct indexing, but it takes a well-informed and engaged advisor to convince them to pursue it for their portfolios. In addition to outlining the advantages of direct indexing, advisors should be prepared to address objections they may hear from investors. These objections may include the following:
Direct indexing is expensive. Advisors can demonstrate how the long-term advantages of direct indexing outweigh the upfront costs. For one thing, it provides customization that they can’t get in ETFs and index funds, customizations that make the portfolio truly reflect their values and circumstances. On top of that, active year-round tax management creates the potential for greater after-tax wealth. As always, it’s up to the advisor to remind the client why account minimums and fees will matter less over the life of the portfolio.
Direct indexing is complex. Owning one ETF or index fund is straightforward enough: one line on a statement, one transaction. Owning hundreds of securities individually sounds messy and complex, bringing to mind images of big stacks of statements. But other people—the direct indexing provider, the investor’s tax provider, and the advisor—deal with the truly complicated steps, while the investors reap the rewards of their customized portfolios. In fact, with the right direct indexing provider, investors should have access to simplified, easy-to-understand reports that bring to life why they’re invested in a direct indexing portfolio in the first place.
The benefits of tax-loss harvesting run out after a few years. It’s true that loss-harvesting potential is greatest in the earlier years of a direct indexing portfolio. It declines over time as losses are harvested, the portfolio’s overall value increases, and its cost basis drops. But direct indexing helps investors manage other portfolio events with enhanced tax efficiency, like deferring gains, managing withdrawals, and donating appreciated securities. This helps investors participate in the market for long periods of time, capturing pretax returns while benefiting from higher after-tax returns and strong diversification.
The bottom line
Investors are increasingly skeptical of advisors’ ability to consistently pick outperforming securities. Judging by the increase in passive investing over the past 20 years, many are content to be the market rather than beat the market. But they also expect a customized experience in many aspects of their lives, from their coffee order to their playlists. Direct indexing can help investors build portfolios as unique as they are—and it can help advisors build deeper and stronger relationships with their clients.