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Advisor Insights

4 Questions About Direct Indexing

Should advisors jump on the bandwagon?

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If its presence at the Future Proof Wealth Festival last month is any indication, direct indexing was a hot topic. It was everywhere—represented at vendor booths, the topic of a popular session, and heard in conversations during breaks. Even outside of the Future Proof bubble, it seems like direct indexing is poised to take the investment industry by storm.

But if you’re like me, you might have a some questions, such as: Is direct indexing really something new? Why would advisors want to use this for their clients? Which provider offers the best platform? Should advisors jump on the bandwagon?

At Future Proof, the session titled “The New Kid on the Block … Or Are They? A Direct Indexing Conversation” attempted to answer these questions and more. It featured a highly knowledgeable panel: Jonathan Hudacko, principal of Personalized Indexing at Vanguard; Gavin Romm, CFA, senior vice president and head of fixed income SMA Solutions for AllianceBernstein; and Blair duQuesnay, CFA, CFP, investment advisor at Ritholtz Wealth Management. Beginning with the basics and moving into the finer points of direct indexing, the panel grabbed the attention of the audience. Here’s what I learned.

Is Direct Indexing New?

Direct indexing is not really a new thing. It is essentially a form of separately managed accounts, or SMAs, which are just what they sound like: accounts that are managed individually (or “separately”). They consist of individual positions combined to implement a particular strategy. Typically, the individual positions are shares of stock, and the strategy is usually (not always) targeted to replicate an index, such as large-cap equities or international stocks. Direct indexing is the same thing except the strategy will always target an index.

Parametric offered one of the early SMAs. It provided individual stock portfolios designed to replicate an index that could be customized based on a client’s stock holdings, gain recognition limits, and desire to exclude securities or categories of securities. In other words, direct indexing could be considered a subset of SMAs.

This doesn’t mean that the new direct indexing trend is all old news. With a realization that SMAs could be beneficial to advisors and clients, as well as better technology, more providers jumped into the solution, striving to improve the ease of use. The new direct-indexing offerings can provide fully flexible portfolios designed not only to replicate an index but also to add tax benefits, social filters, and exclusions. These new platforms have start-to-finish, sleek online tools that can analyze transition options, create proposals, provide engagement letters and investment policy statements, and allow for regular and ongoing monitoring.

Why Would Advisors Want to Use Direct Indexing?

Advisors should be interested in direct indexing for the benefit of clients and themselves. There are four categories of benefits to clients:

  1. Tax benefits.
  2. Ability to exclude securities.
  3. Ability to exclude categories.
  4. Ability to diversify concentrated stock positions.

There are three main types of direct-indexing tax benefits (for taxable accounts only, obviously). Tax-loss harvesting is what most providers talk about, because the benefit can be truly material. With a portfolio of individual securities, rather than mutual funds, there are more-frequent opportunities for generating tax losses. Second, with a greater range of securities, it is also easier to avoid short-term gains. Finally, because the investor is not holding mutual funds, there are no capital gains distributions.

The ability to exclude securities is most useful when the investor works at a large company with stock benefits. For example, a pilot for American Airlines AAL, who has a significant amount of company stock (or options), might want to avoid holding that stock in their investment portfolio. After discussion between the advisor and client, it might even make sense to eliminate airline holdings altogether. The direct-indexing account can be designed to closely replicate a large-cap index without the airline holdings.

It can also exclude categories of securities. Let’s say you have a client who wants to avoid companies that test on animals or produce tobacco products. A direct-indexing account can be a perfect vehicle for this. Of course, the more categories that are excluded, the greater the tracking error from the index.

Finally, investors with low-basis concentrated positions can incorporate those securities into a direct-indexing account. By using the securities within the portfolio, gain recognition can be minimized. For example, an investor with $500,000 cash and $500,000 of low-basis Apple AAPL stock desires a $1 million large-cap portfolio. The direct-indexing provider determines that the large-cap portfolio can absorb $100,000 of Apple stock for a 1% tracking error, or can absorb $250,000 of Apple stock for a 5% tracking error. After discussion between the advisor and client, the client decides to go with the 5% tracking error choice, and thus only must sell the remaining $250,000 of Apple stock. Other options might be adding outside cash and gradually selling the remaining Apple stock as harvested tax losses provide offsets.

Clearly, there are significant direct-indexing advantages to the investor. But there also are several benefits to the advisor:

  1. Ability to offer custom portfolios to clients.
  2. Powerful (and no-effort) tax management.
  3. Ability to integrate direct-indexing accounts with other holdings, like mutual funds and exchange-traded funds. (A robust rebalancing software like Morningstar’s Total Rebalance Expert can seamlessly provide the integration.)

Which Provider Offers the Best Direct-Indexing Platform?

The choice of the best platform is dependent upon the needs of the advisor and the client. All direct-indexing providers offer the same general service. They differ mainly in the areas of pricing, minimum balances, types of indexes offered, amount of customization offered, how variance from the index is quantified, amount of automation, availability at particular custodians, and reputation of the provider.

Direct-indexing providers at Future Proof included AllianceBernstein, DFA, Morningstar, O’Shaughnessy Asset Management, and Vanguard. Information on any platform is available from the provider. (Morningstar’s direct-indexing offering is currently in prerelease, with full release coming soon.)

Of course, there are many more direct-indexing providers, including Fidelity, Schwab, BlackRock, Goldman Sachs, and others. To reiterate, choosing the best provider for you and your clients will require looking at the details and deciding which factors are most important to you. You might want to start with providers that can be accessed through the custodians you work with. Maybe identify which types of indexes you’d like to start with for your clients. Then consider the other factors listed above.

Should You Jump on the Direct-Indexing Bandwagon?

In my opinion, yes. It makes total sense for new money—no gains to implement, customized to the client, and complete tax management. For clients with a significant portion of their investments in retirement accounts, a direct-indexing solution can be great even though tax benefits aren’t a factor. The ability to customize can be quite meaningful for clients. For taxable accounts with significant gains, it’s best to consider it case by case, especially for some parts of the portfolio such as broad U.S. indexes or U.S. large-cap. Finally, for clients with low-basis concentrated positions, to the extent that exchange funds, or swap funds, aren’t available and charitable remainder trusts are not adequate, consider the direct-indexing solution. Even if you can’t diversify everything at once, at least you’ll be taking the first step.

Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Morningstar, Inc. does not market, sell, or make any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

The views expressed in this article do not necessarily reflect the views of Morningstar.

About Morningstar, Inc. Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The Company offers an extensive line of products and services for individual investors, financial advisors, asset managers and owners, retirement plan providers and sponsors, and institutional investors in the debt and private capital markets. Morningstar provides data and research insights on a wide range of investment offerings, including managed investment products, publicly listed companies, private capital markets, debt securities, and real-time global market data. Morningstar also offers investment management services through its investment advisory subsidiaries, with approximately $251 billion in assets under advisement and management as of June 30, 2021. The Company has operations in 29 countries. For more information, visit www.morningstar.com/company. Follow Morningstar on Twitter @MorningstarInc.

Sheryl Rowling does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.