Direct Indexing

Direct indexing is a form of passive investing that enables direct ownership of the individual securities that compose a benchmark. Unlike an ETF or other commingled fund, it gives an investor greater control, allowing for tax-loss harvesting at the security level, customization around ESG preferences, and other advantages.

What makes direct indexing so compelling?

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Tax

Third-party research has shown that tax management can add 1%–2% in after-tax excess returns.*

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Flexibility

Investors can use direct indexing to escape concentrated positions, optimize charitable giving, and more.

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Customization

Clients can choose from equities or fixed income, blending benchmarks to get the precise exposure they seek.

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ESG

From screens to proxy voting and more, investors can align a portfolio with their environmental and social values.

* Shomesh E. Chaudhuri, Terence C. Burnham, and Andrew W. Lo. 2020. “An Empirical Evaluation of Tax-Loss-Harvesting Alpha.” Financial Analysts Journal 76:3, 99–108. This study did not involve Parametric or its clients. There is no guarantee that a tax-management strategy will result in increased after-tax returns. Results will differ based on an individual investor’s circumstances.

CERULLI ASSOCIATES REPORT

The Case for Direct Indexing: Differentiation in a Competitive Marketplace

Researchers at Cerulli Associates got the global investment industry talking in 2021 with a bold prediction: that growth in direct indexing, pioneered by Parametric, would outpace both ETFs and mutual funds. This year they’re back with deeper insights into this new investing frontier, featuring case studies from advisors putting direct indexing to work for their clients. You’ll find out:

Where firms are finding opportunities to scale up and stand out with direct indexing

Why tax management is at the core of direct indexing solutions

How advisory firms use direct indexing to address a wide range of client needs

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Learn more from Cerulli Associates in their 2021 report Improving Client Experience: Customizing with Direct Indexing.

Evolution of passive investing: from “bulk beta” to personalization

A list of attributes for index mutual funds including being inexpensive, the market performance (beta), but the structure is relatively inefficient (costs and taxes).

A list of attributes for index ETFs including being less expensive and having better tax treatment, but the bulk data is not customizable, investors can’t harvest tax losses, and it’s not appropriate for all asset classes.

A list of attributes for direct indexing including lower fees than active managers, rules-based and market like returns, greater customization, and tax advantages not available in ETFs.

A scale of tax efficiency and customization from less to more. Index mutual funds are on the less end, index ETFs are in the middle, and direct indexing is on the more end of the scale.

Customize with confidence

Risk management is embedded in the rules-based models that form the foundation of our decision-making and portfolio construction processes.

We measure risks through tracking error, which we aim to control in three key ways:

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Keeping exposures similar to investors’ chosen benchmarks

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Trading only when the value add justifies the cost

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Staying mindful of IRS wash-sale rules

Which types of investors benefit most from direct indexing?

Direct indexing offers a number of advantages, but it may not be ideal for all investors.

If you’re weighing whether the strategy is right for your clients, consider those with an interest in one or more of the following:

Transitioning assets

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Transitioning assets

Unlike an ETF, you can fund a direct indexing portfolio with cash or existing securities—potentially lessening the tax impact of transition.

Reducing capital gains tax

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Reducing capital gains tax

Unlike an ETF, direct indexing systematically harvests losses at the security level, so your clients can offset gains elsewhere in their holdings.

ESG

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ESG

Direct indexing allows for robust screening, so you can align a client’s passive portfolio with their environmental or social values.

Charitable giving

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Charitable giving

Unlike an ETF, direct indexing allows your clients to gift individual securities to charities or heirs, potentially lessening the tax impact of appreciated holdings.

By owning the underlying securities of a passive allocation, investors can tailor their portfolios to reflect their environmental and social principles.

Learn more about responsible investing at Parametric >>

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of affluent investors preferred to invest in companies that have a "positive social or environmental impact."

Source: Cerulli Associates

FIXED INCOME

The investment universe isn’t limited to equities. Neither is direct indexing.

You can also build a fixed income account that follows popular benchmarks, providing broad exposure to bonds. Just as with equities, a bond portfolio can be actively tax managed, harvesting any losses year-round when the opportunities arise, so your clients can use them to offset realized capital gains elsewhere in their broader holdings.

Direct indexing at Parametric:

Custom Core®

Equities or fixed income? One benchmark or a combination of benchmarks? ESG screens, single-stock exclusions, or both? With Parametric Custom Core, your clients get to make passive investing personal, and you get to enhance your value by tailoring a tax-managed portfolio around their precise needs.

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An idea that’s 30 years new

Parametric pioneered custom passive portfolios close to 30 years ago. Today we remain the leading provider of direct indexing, and we continue to demonstrate its value to advisors and their clients. Download our direct indexing guide—and get in touch to learn more about how Parametric can help you grow your practice.

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