It’s a well-known secret that direct indexing is on the rise. As investors continue to seek out more customization and greater control over their investment portfolios, advisors must continually find new ways to meet those expectations. Technology has made it possible for advisors to do just that and in doing so, set themselves apart from the competition.
The Next Big Wave of Opportunity
Direct indexing offers unique benefits that can’t be replicated in a mutual fund or ETF — especially when it comes to personalization and tax management. Investing in a mutual fund or EFT means holding all of the positions within that fund or ETF. With direct indexing, investors own each individual position within the index they select. As such, they can personalize their strategy by adding or removing specific stocks, creating a truly customized version of that index. This level of control provides an increased ability to manage taxable gains and losses on an ongoing basis.
As of the end of last year, only about 14% of financial advisors were aware of and actively recommending direct indexing solutions to their clients, according to a 2022 Cerulli report. That same report also notes that the expanding demand for direct indexing strategies will lead to asset growth of over 12% — reaching an estimated $825 billion by the end of 2026.¹
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The Affluent Investor Appeal
The most widely regarded aspects of direct indexing are the tax benefits. And while most investors would consider themselves “tax-averse,” mass affluent and high-net-worth investors are likely even more interested in investing strategies that can help them manage their tax burden.
Another stat from Cerulli reveals that while 68% of investors believe that an account that minimizes taxes is the most desirable feature of that account, the percentage increases to 100% for high-net-worth investors. Yet, only 63% of financial advisors target clients with at least $500,000 in investable assets and only 14% target those with more than $5 million.¹ The tax and personalization options afforded by direct indexing can offer significant benefits to affluent and high-net-worth investors, especially when compared to mutual funds and ETFs.
To help advisors understand some of the applications of this emerging approach and set themselves apart from their competition, let’s look at four cases for direct indexing that you can implement today with Orion Custom Indexing.
Use Case 1: Create Tax Alpha
Direct indexing isn’t a new concept. But what has helped bring it to the forefront of the wealth management stage is the evolution of technology that makes it possible to automate tax optimization. This systematic tax management can help overcome the limits of human-driven, manual processes and create additional returns for clients through tax alpha.
Clients understand the concept of “it’s not what you make, it’s what you keep.” Direct indexing enables advisors to create value to clients, potentially adding tax alpha to client portfolios through:
- Tax loss harvesting: Offsetting the gains of underlying positions with the losses of other underlying positions, helping to reduce tax liability
- Deferring capital gains: Avoiding the sale of the positions with the highest gains without losses to offset them
Direct indexing continually optimizes portfolios for taxes, which can create quantifiable value for clients that they can easily see during tax season. And in many cases, the money clients save by using direct indexing for tax management can offset the costs associated with direct indexing.
Use Case 2: ESG Investing
The demand for ESG is growing. According to PwC, ESG assets will more than double in the US, totalling $10.5 trillion by 2026.² At the same time, it’s estimated that $84 trillion in assets will transfer to the next generation of investors over the next two decades.¹
That sets up an opportunity for advisors to attract younger, next gen investors by offering strategies that align with their values. And Cerulli data highlights how values-based investing becomes increasingly more important the younger investors are.
Percentage of investors who prefer to invest in a manner that reflects their personal values:³
- 49% of retail investors (all ages)
- 61% of investors ages 40-49
- 75% of investors who are younger than 40
Advisors will see generational wealth transitioning to younger clients who are far more likely to be interested in environmental, social, and governance (ESG) investing. Direct indexing fits exceedingly well with ESG, giving advisors flexibility to build portfolios that best match the goals, objectives, beliefs, and values of clients.
Use Case 3: Planned Charitable Giving
Currently 47% of advisors offer charitable giving advice to their clients. But only 7% of affluent investors report that their advisors assist them with charitable giving¹, meaning many do not leverage their advisor for help with their charitable strategies.
Direct indexing can help clients establish an effective charitable giving strategy, especially those clients with highly appreciated stock positions or other low-cost basis stocks. Those positions can be donated to the charity they choose or to a donor-advised fund. If the client has money earmarked for charity, they can instead use the money to buy new securities within the portfolio. This helps the client to reset the cost basis, avoid realizing the associated tax gain, and invest more tax efficiently.
Use Case 4: (Effectively) Diversify Concentrated Positions
Concentrated positions within client portfolios can be challenging, especially for advisors working with affluent clients. These positions are often accumulated over many years — sometimes as part of a compensation package over an entire career. Or they may have been passed down from a family member or trust. In many cases, they have very low cost basis, creating the potential for a significant tax liability if the position were to be sold.
Direct indexing can help advisors navigate these challenges and make concentrated positions less burdensome to diversify. The inherent flexibility of direct indexing gives advisors multiple ways to unwind highly appreciated securities, including:
- Tax-loss harvesting: Advisors can implement direct indexing to harvest losses. Those losses can be used to offset the gains incurred from the sale of some of the concentrated positions. The proceeds of those sales can be reinvested back into the diversified portfolio.
- Planned charitable giving: Another way direct indexing can be used is to be paired with a planned giving strategy. Advisors and clients can leverage a donor-advised fund to gift appreciated stock positions and realize additional tax savings.
Which of Your Clients Could Benefit from Direct Indexing?
To meet the evolving needs of clients, advisors need scalable ways to add value and differentiate their business. Direct indexing benefits such as tax management, customization, and alignment with a clients’ values, enable advisors to deliver bespoke, personalized and customized portfolios for clients.
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