If you haven’t considered direct indexing as a valuable solution for some of your clients, what are you waiting for? You probably already have clients that could benefit from this growing approach.
As you likely know by now, direct indexing offers clients a custom investment portfolio that mirrors the composition of an index. But rather than buying a mutual fund or exchange-traded fund, direct indexing is fully customizable and allows investors to tailor their portfolio to their specific preferences and investment goals.
With benefits like tax advantages and the ability to create customized portfolios that reflect values-based or environmental, social or governmental preferences, direct indexing is growing and expected to reach $800 billion in assets by 2026, according to Cerulli.1 And, continuously improving technology has made direct indexing more affordable and accessible than ever.
So how do you know when it’s the right solution to offer? Here are five things clients need that can be addressed with direct indexing for better investment outcomes.
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Client Need #1: Tax Control
Arguably the most important benefit of direct indexing is the tax control it offers. The very nature of direct indexing gives investors the ability to manage their tax liability through tax loss harvesting, which can help reduce their overall tax burden and yield better after-tax returns.
With direct indexing, investors own the individual securities within the portfolio. As such, positions that are underperforming can be sold to be replaced with similar holdings. The loss incurred can be leveraged to offset gains elsewhere in the portfolio. For investors with substantial gains in their portfolio, this strategy is especially helpful to help chip away at their tax burden.
Tax loss harvesting gives investors the power to eliminate positions that are not performing well and replace them with assets that are expected to perform better. With a mutual fund or ETF, investors can sell and replace shares at the fund level, but that means they are also potentially giving up allocations to positive performers within the fund. With direct indexing, investors can zero in on those underperformers and leverage those losses to offset gains elsewhere. And a key feature of tax loss harvesting is the ability to use losses to offset gains either right away or carry them forward to offset gains in the future.
The strategy is consistently effective consistently across market conditions, not just when the market is up. Bloomberg reports that “direct indexing providers estimate this kind of tax-loss harvesting could raise returns by about 1% a year.”¹
Client Need #2: Valued-Based Strategies
As more clients embrace environmental, social and governance (ESG) criteria or socially responsible investing (SRI), direct indexing becomes a valuable strategy. Unlike a mutual fund where the portfolio manager decides which companies to invest in, direct indexing enables investors to simply choose the index they wish to replicate and include or exclude the securities or sectors to align with their values.
This feature gives investors the ability to truly personalize their portfolio. Whether they want to choose or reject individual holdings that don’t meet their criteria, investors looking for ESG, SRI, or faith-based portfolios can include exactly the holdings they want.
As this type of investing gains prominence — McKinsey reports that more than 90 percent of S&P 500 companies now publish ESG reports in some form² — and the demand for customization continues to rise (see client need #5), direct indexing is poised to deliver.
Client Need #3: Transitioning to a More Targeted Portfolio
When investors with an existing portfolio are transitioning to a new portfolio, they can incur significant tax consequences by simply cashing out of existing holdings and buying new securities. Careful tax planning can help clients avoid being burdened with heavy tax liabilities.
Direct indexing enables clients to move their existing holdings directly into the new portfolio and manage the tax liability on their terms — either with a specific tax budget or over a specified number of years. This helps clients control taxes and enjoy better after-tax returns.
Client Need #4: Diversification of Concentrated Holdings
Investors who have received equity compensation from their employer may need to find ways to diversify their portfolio. When that equity is given as stock share, those positions often have a low-cost basis — making them hard to get out of without a tax hit. Over time, as those positions accumulate, they represent concentrated holdings within the portfolio.
Investors can leverage direct indexing to diversify their portfolio and, by taking losses in a direct indexing portfolio, use the losses to offset gains from the sale of shares from the concentrated position. This helps investors to more tax efficiently reduce their exposure to the concentrated position, reduce their risk, and potentially improve the after-tax return of the portfolio.
Client Need #5: Personalized Portfolios
Outside of ESG or other values-based methodologies, many investors are looking for other ways to personalize their investment experiences. They may choose to allocate more money into the sector they work in, or with companies they know and trust. Or they may want to exclude a sector or companies that they are already invested in through other means. A direct indexing strategy offers investors the ability to replicate an index and simply include or exclude a sector or company based on their preferences.
In short, you can use direct indexing to help meet a wide range of client needs, including managing their taxes, customizing their investments, or more efficiently transitioning their assets to a more optimized portfolio. The benefits for investors are clear:
- Customized portfolios that meet their specific investment objectives, tax requirements, and environmental, social, and faith-based preferences
- Improve after-tax returns, lessen their tax burden, and minimize capital gains when buying or selling within their portfolio
Want to offer powerful personalization to every client? Find out more about Orion Custom Indexing here and learn how easy it is to get started.
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¹Source: "How to Invest with Direct Indexing," Forbes Advisor, March 2023
²Source: ”Does ESG really matter – and why?” McKinsey, August 2022