A report from Cerulli Associates surveys the investment industry’s expanding direct indexing landscape. Learn what’s on the map and what remains to be discovered.
It feels like everything is out of our hands today, personally or as investors. We see our lives and the markets shifting daily with the latest medical, political, economic, and climate news. Social media and the 24/7 news cycle add to this unease. What can investors do about it? Control what they can control. This is a good time for investors to take control of their risks, values, and taxes. The finance industry agrees—and it’s making it easier for investors to do so.
One of the most exciting developments in the finance industry in recent years has been the rise of direct indexing—owning the individual securities in a passive portfolio, with the added upside of a variety of customizations built for the specific investor. Several major players have added direct indexing capabilities, largely by acquiring its earliest entrants. Parametric, regarded as a pioneer of customized separately managed accounts (SMAs), was among the first of these acquisitions, becoming a part of Morgan Stanley Investment Management (MSIM) in the second quarter of 2021.
Direct indexing is nothing new at Parametric, but it can be both compelling and confusing for investors. Yet it can unlock numerous rewards if it’s done right, and not just in dollars. Market researchers Cerulli Associates published an August 2021 report on the present and future of the direct indexing landscape. They surveyed financial advisors, account managers, wealth managers, and retail investors to find out what’s already known about direct indexing and what remains to be discovered. Let’s look at what “done right” means for both investors and their advisors.
Managing investment taxes
A key advantage of direct indexing is maximum flexibility when it comes to managing tax losses and gains throughout the year at the individual security level. Tax-loss harvesting predates direct indexing, and it’s a feature of some other asset management solutions, such as model-traded or manager-traded SMAs. However, direct indexing allows clients to buy or sell securities in an index on an individual basis, according to risk controls they specify—and without drifting too far from their target risk tolerance or tracking error.
Many advisors currently wait until the end of the year to review their clients’ portfolios for loss-harvesting opportunities. Unfortunately, only a few opportunities wait that long. A year-round, rules-based loss-harvesting method creates the potential for higher tax alpha, particularly during global market disruptions.
By harnessing the power of tax-loss harvesting through direct indexing, advisors can set themselves apart from their competitors and add value for their clients. The benefits of loss harvesting can be difficult for even experienced investors to understand, yet the quantifiable tax savings are a compelling proof point to show that an advisor is earning their fee.
Aligning portfolios with principles
Many advisors told Cerulli that clients often discuss personal priorities outside their finances. They’re eager to build portfolios that not only generate maximum after-tax returns but reflect their personal values and opinions. Often advisors get the chance to introduce responsible investing to their clients, who reportedly “light up” as they learn more about available environmental, social, and governance (ESG) approaches.
The term ESG tends to make people think first of the environment—for example, how companies are working to lower carbon emissions or whether they test their products on animals. The COVID-19 pandemic brought the two other facets of ESG into the limelight. Now investors might demand that companies do more to protect their employees from public health risks or keep a closer eye on diversity in their workforces. Or they may want to construct portfolios that won’t force them to compromise their religious beliefs. The only consistent truth about ESG is that every client defines it their own way.
This reality can make the advisor’s job a little more complicated than simply investing their clients’ money in some securities and keeping it out of others. However, with 44% of wealthy investors preferring to invest in companies with a “positive social or environmental impact,” navigating the complexities of ESG is becoming a must. Here direct indexing offers yet another benefit: a way for investors to express their responsible investing principles while gaining their target market exposure and risk characteristics.
Create a flexible, personalized portfolio for your clients
Gone are the days when a financial advisor could focus almost exclusively on seeking market-beating performance for their clients. Investors have more data and more tools at their fingertips than ever before. They have stronger ideas about what they want—and don’t want—in their portfolios. While some investors have the time and energy to jump on up-to-the-minute trading opportunities, most want to build wealth for the long term, and they want to feel secure in the way they’ve chosen to do it.
Perhaps most importantly, investors don’t want to feel like they’re wasting money to make money. That’s a big reason why advisors expect to increase their allocations to low-fee exchange-traded funds (ETFs) to 19% in 2022, according to Cerulli’s survey. Investors are increasingly skeptical that traditional active management can help them beat the market. Instead they’re content to be the market instead, even if it means occasionally missing out on higher returns. This is particularly true as investors become more aware of advisor fees and commissions, which many still pay without realizing it.
These are some of the biggest pressures on advisors to demonstrate their value. Luckily, the growth in customized investment solutions offers multiple ways to overcome these challenges. Investors may pay less upfront to buy and hold passive ETFs, but they may also pay more in taxes if they can’t harvest losses at the security level. Those ETFs may be branded ESG or responsible, but the provider’s idea of ESG and responsible investing may differ wildly from the investor’s idea. A passive portfolio may generate enough returns to please the investor, but they may not have considered how those returns can fit into a comprehensive financial plan.
With direct indexing, advisors can provide investors with the reliability of a rules-based portfolio strategy, the enhanced alpha of tax-loss harvesting, and the personal satisfaction of responsible investing. But scalable and customizable financial solutions don’t stop there. Advisors can also expand their client offerings with services in estate planning, business planning, and charitable giving. As investors’ net worth grows, so does their need for a skilled and resourceful partner with a holistic view into their finances.
The bottom line
All these capabilities help investors control what they can control: rules-based strategies, tax-loss harvesting, responsible investing. This may be new to many investors, but direct indexing isn’t actually new at all: At its core it’s a mixture of customizations that Parametric has spent more than 30 years pioneering and perfecting. As the market’s largest and most established provider of custom SMAs, we’re well positioned to support both clients and advisors on their direct indexing journey.
There is no assurance that a separately managed account (SMA) will achieve its investment objective. SMAs are subject to market risk, which is the possibility that the market values of the securities in an account will decline and that the value of the securities may therefore be less than what you paid for them. Market values can change daily due to economic and other events (natural disasters, health crises, terrorism, conflicts, social unrest, etc.) that affect markets, countries, companies, or governments. It is difficult to predict the timing, duration, and potential adverse effects (portfolio liquidity, etc.) of events. Accordingly, you can lose money investing in an SMA.
Comparing the management and/or performance of a separate account to a mutual fund or exchange-traded fund is not a true and equal comparison due to differences in guidelines and restrictions, fees and expenses, and cash flows, among other factors. Because of these disparities, investors and clients are cautioned against undue reliance on separate account and fund performance comparisons.
Investment strategies that seek to enhance after-tax performance may be unable to fully realize strategic gains or harvest losses due to various factors. Market conditions may limit the ability to generate tax losses. Tax-loss harvesting involves the risks that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. Also, a tax-managed strategy may cause a client portfolio to hold a security in order to achieve more favorable tax treatment or to sell a security in order to create tax losses. Prospective investors should consult with a tax or legal advisor before making any investment decision.
