Financial advisors are leaning into direct investing to offer personalized, tax-smart strategies to their clients and use it as scalable way to grow their business.
Direct indexing is an investment strategy in which investors purchase the underlying positions within a selected index and have the ability to customize that portfolio by adding or removing individual positions. The portfolio is intended to replicate the performance of an index by purchasing the underlying shares of an index to create a customized portfolio. While direct indexing is not new, it has gained significant traction in the past few years as technology has made it possible for advisors to access and implement with clients.
With benefits like tax advantages, the ability to create customized portfolios reflecting values-based preferences, direct indexing is growing. Assets are expected to reach $800 billion by 2026, outpacing both ETFs and mutual funds.1
With direct indexing, advisors now have access to meet an individual investor’s needs by:
- Offering personalized, tax-efficient portfolios across their client base
- Helping manage clients’ tax liability through tax transition, tax loss harvesting, capital gains budgets, and tax optimized portfolio rebalancing
- Appealing to investors focused on ESG and other values-based investing
- Attracting and retaining high-net-worth clients with solutions that address their tax management and customization needs
- Leveraging technology to streamline processes and reduce manual operations
- Uncovering additional revenue opportunities to grow their advisory business
As investors across the board expect more personalized services, direct indexing is a valuable differentiator for advisors to position their service offering to help clients reach their goals. In the past, the ability to offer personalized portfolios and tax optimization would require significant resources and might have only been offered by larger institutions or only to high net worth clients above a certain asset threshold.
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Introducing a new type of investment strategy means helping clients understand it. Let’s take a look at some of the most common client questions about direct indexing and how to address them.
1. Taxes
One of the biggest features of direct indexing is the tax benefits it can offer. Because investors own the underlying positions directly, there are multiple opportunities to reduce taxes, including harvesting losses to offset gains within the portfolio and the ability to optimize the portfolio for taxes when rebalancing.
Investors can add or omit positions based on their tax implications. For example, positions that are underperforming can be sold and replaced with similar holdings that are expected to perform better. The loss incurred can then be leveraged to offset gains elsewhere in the portfolio.
Mutual funds and ETFs enable investors to 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 right away – or carry them forward to offset future gains.
The tax advantages of direct indexing make it a strong case for investors with substantial tax concerns, such as affluent investors in higher tax brackets. Investors with large gains in their existing portfolio could consider direct indexing to help manage taxes as they transition to a more tax efficient strategy.
Using direct indexing to help manage taxes can be effective regardless of market conditions. Bloomberg reports that tax-loss harvesting could raise returns by about 1% a year, as reported by direct indexing providers.2 The quantifiable value of the tax savings incurred from direct indexing may help advisors when discussing fees with clients.
2. Costs and Suitability
The cost for most direct indexing strategies tends to be higher than a low-cost, passive ETF. It’s an investment strategy that is generally better suited for investors who are affluent and have higher gains in their portfolio where the tax savings help justify the cost. Traditionally, direct indexing strategies were only available at higher investment levels but technology has evolved to open access for lower-end investors.
Direct indexing provides key advantages for certain investors who are looking for relatively cost-effective personalization and customization in their investments. Due to the fact that it’s more expensive than a low-cost ETF, it should be used for investors who are committed to taking a long-term approach and working with their advisor to stay on track to reach their goals.
3. Alignment
One of the reasons for the growth of direct indexing over the past few years is the increase in interest around environmental, social and governance (ESG) or socially responsible investing (SRI). Unlike mutual funds where portfolio managers decide which companies to invest in, direct indexing enables investors to simply choose the index they wish to replicate and include or exclude the positions to correspond with their preferences and values.
ESG investing is growing with more than 90% of S&P 500 companies now publishing ESG reports in some form.3
Direct indexing technology enables advisors to finely tune the portfolios of clients who favor an ESG or values-based approach by including or excluding certain companies or sectors and find suitable replacements to maintain alignment with the chosen index. This level of customization makes direct indexing more suitable than an ETF for investors committed to this approach.
4. Complexity
Direct indexing has clear benefits but it is best leveraged as part of a disciplined approach. While the basic idea of direct indexing is fairly straightforward, the mechanics of it might be a little more complex and it can be more complicated than simply owning a fund. Because investors own the underlying positions, the statement and reporting may be more confusing than they are used to with their mutual funds and ETFs.
Advisors should partner with a provider that offers a scalable technology platform to help make the process less complex and more accessible for clients. Intuitive tools and clear reporting can also help to keep both advisors and clients fully informed.
5. Portfolio Diversification
With funds and ETFs that track an index, you get every holding that’s part of the index. One of the selling features of direct indexing is the ability to tailor the holdings to align with preferences, goals, or values. In certain situations, this customization is a way for investors with concentrated positions to be able to better diversify their portfolio. An example might be an investor who received equity compensation from their employer and now finds themselves holding a significant amount of a low cost basis or highly appreciated (or both) stock.
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.
When is Direct Indexing the Right Solution for Clients?
As investor expectations around personalization and investment technology continue to evolve, direct indexing is likely to continue to be a growing strategy. The benefits—from tax management to personalization—are clear. But as with any investing strategy, the benefits must be weighed carefully against factors like costs, goals, wealth level, and investment circumstances.
For the right investors, direct indexing gives advisors a valuable tool to offer bespoke, high-value, professionally managed portfolios that are customized according to their unique needs and objectives.
Find out how Orion Custom Indexing can help offer powerful personalization for every investor.
1Source: Cerulli Associates, The Case for Direct Indexing: Differentiation in a Competitive Marketplace, December 2022
2Source: Forbes Advisor, "How to Invest with Direct Indexing," March 2023
3Source: McKinsey, Does ESG really matter – and why? (Quarterly), August 2022
1875-OPS-7/13/2023
Orion Portfolio Solutions, LLC, an Orion Company, is a registered investment advisor.
Custom Indexing offered through Orion Portfolio Solutions, LLC a registered investment advisor.
The views expressed herein are exclusively those of Orion Portfolio Solutions, LLC, a registered Investment Advisor, and are not meant as investment advice and are subject to change. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person.
Wealth Management services are offered by Orion Portfolio Solutions, LLC d/b/a Brinker Capital Investments a registered investment advisor.