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How Can Advisors Use Direct Indexing to Deepen Client Relationships?

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Brian Langstraat, CFA

Chief Executive Officer

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Passive investing is changing, and the role of the financial advisor is changing with it. Find out how direct indexing fits into this shift.

At Parametric, we’re big fans of investment advisors. We’ve seen high-quality advisors make crucial differences in investors’ financial lives over and over again. When we think about how to build and manage investment portfolios for our wealth-management clients, we’re almost always thinking in the construct of long-term advisor-client relationships. 

Our direct indexing offerings in equity and fixed income exemplify our advisor focus especially well. We originally built our first direct indexing solutions in 1992, in response to an advisor’s wish for enhanced tax efficiency. Today our advisor partners use our flagship direct indexing offering—customized, broad-market separately managed accounts (SMAs)—to connect with clients on big topics like active vs. passive management; environmental, social, and governance (ESG) guidelines; charitable giving; and tax-aware portfolio transitions. And while basic tax efficiency is still a powerful and compelling benefit of direct indexing 30 years later, advisors now dig deeper with their clients. Here are three areas of particular value.

An optimal active/passive private wealth portfolio often includes direct indexing 

All advisors have to explicitly or implicitly take a position on allocating to active or passive strategies in public market investing. While some allocate 100% of their clients’ assets to one choice or the other, many carefully consider market efficiency, manager skill, and fees and taxes, leading them to incorporate both investing styles. The customization inherent in a direct indexing solution creates a richer active/passive discussion, since accessing broad market exposure or beta in a custom SMA can add tax efficiency, ease of portfolio transitioning, and custom ESG guidelines to the analysis. 

Most portfolios end up with allocations to both active and passive strategies. Advisors and clients embrace direct indexing to improve the tax and fee efficiency of the overall portfolio. The best way to build a combined active/passive allocation while considering both fees and taxes is one of Parametric’s most frequently asked research questions.

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There’s more to successful tax management than year-end loss harvesting

Capital loss harvesting is increasingly popular in the lexicon of investment advice in the United States. Loss harvesting means selling a single security or basket of securities trading at a loss and buying securities of a similar risk-return profile. These realized losses can be used to offset realized capital gains in current or future tax years. As a result, taxes are deferred or avoided, and clients’ after-tax wealth is enhanced. Many investors and advisors do this on an ad hoc basis, often near the end of the tax year. But advisors who embrace the full power of direct indexing know that valuable tax management extends far beyond year-end loss harvesting. 

Direct indexing can and should incorporate careful, risk-controlled loss harvesting all year round. But the flexibility of a custom SMA extends much further. Advisors can manage portfolios for greater tax efficiency at inception, giving clients control over how much they’ll pay to move their holdings from one strategy or structure to another. This was a favorite benefit of direct indexing among advisors responding to a recent Cerulli Associates survey. As well, charitable giving from a well-managed direct indexing portfolio can simultaneously reduce unrealized gains and improve portfolio risk control while accomplishing the desired charitable intent. Gifting appreciated securities to charity helps sidestep the capital gains tax that would normally be applied to stock sales.

Our research in the early 1990s demonstrated that taxes can be a bigger drag on long-term performance than fees or trading costs. That holds true today. We’re pleased to support successful advisors as they engage with clients in this valuable conversation.

A client’s definition of responsible investing is the definition that matters

A big surprise for us from the recent Cerulli Associates survey was what some advisors had to say about responsible investing—another facet of portfolio management that’s only getting more attention by the day. Three responses stood out the most:

Demand for responsible investing is too low to make it a worthwhile offering.

Responsible investing is too political to discuss with clients.

The boundaries of responsible investing are unclear.

Clearly ESG and responsible investing conversations can be tricky for many advisors, and they need more tools and education. A custom broad-market SMA can be of significant help in advancing advisor-client conversations in this area. The flexibility to incorporate basic screens or restrictions can often be a powerful first step. Discussions of active ownership and proxy voting might create a sense of engagement and clarity, as does clear reporting on portfolio holdings and characteristics.  

Ultimately responsible investing isn’t exclusive to any particular belief system. One investor who wants fossil-fuel producers out of their portfolio can use the same portfolio-construction methods as another investor who will only hold companies with practices in line with their faith. One investor whose wants to see more women on corporate boards can submit a similar type of proxy vote to that of another investor who wants to see more people of color in management. No matter the client’s politics, religion, or priorities, direct indexing gives advisors a way to align their financial goals with their principles.

The bottom line

The role of the investment advisor has evolved quite extensively over the past decade. While security selection and manager evaluation still play a role, successful advice means engaging in client conversations across many dimensions. Some of the most important dimensions are macro in nature: portfolio construction, taxes, and ESG, just to name a few. Conversations in these areas can lead to advice that makes a difference, and direct indexing can help.  

We at Parametric have always believed in questioning the status quo and exploring new ways to help advisors serve their clients. It’s just that kind of curiosity that led us to pioneer direct indexing in the first place. We’re here to share what we’ve learned.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.