Direct indexing offers advisers opportunities to engage with clients

Institutional investors have used direct indexing for years, but it’s finally becoming available in the retail market, allowing smaller investors to invest directly in companies at the portfolio level.

The best of the use cases touted for direct indexing are personalization and tax strategies, said Cindy Galiano, head of product for Morningstar Investment Management. Direct indexing gives advisers the ability and flexibility to personalize a client’s preferences, especially when it comes to environmental, social and governance investing, and it can help to diversify clients away from concentrated risk exposures.

More broadly, direct indexing can be even more efficient than exchange-traded funds from a tax standpoint since it allows tax-saving strategies at the individual security level that aren't possible at the fund level, Galiano added. She spoke Tuesday on a panel about direct indexing at the Morningstar Investment conference in Chicago.

Direct indexing is the practice of building a portfolio of individual securities that’s meant to track an index such as the S&P 500. However, instead of buying each security in that index, direct indexing uses an optimizer that strives to replicate and closely track the index, but with fewer constituents, Galiano explained.

Robust technology allows direct indexing to scale, providing personalization across clients, and the technology helps on the tax side because it has the ability to tax-loss harvest automatically on a daily basis, rather than waiting until the end of the year or during tax season, Galiano said. It can help advisers avoid triggering wash sales as well.

PERSONALIZATION NOT A FAD

Another member of the panel, Peter Dietrich, head of wealth at Morningstar Indexes, said that personalization is not a fad, but a trend. Personalization will start to become part of the investment process, he said, just as risk tolerance questionnaires are now embedded in discussions with clients.

Direct indexing also allows advisers to engage with younger clients who are interested in ESG investing, Dietrich said. Looking at demographics, Gen X and millennials currently hold roughly one-third of U.S. wealth and they will also benefit from the massive wealth transfer from baby boomers; it’s up to advisers to talk to that generation about their investing preferences.

Because direct indexing allows more personalization, it can allow for deeper conversation, Galiano said.

“It's no longer just a PDF report with trailing investment performance," she said. "There's a story in terms of how your values and the way you invest are aligning to your goals. And it's a powerful narrative.”

Advisers can choose from a variety of direct index providers, Galiano said, and she offered some tips on how to choose one. Among the questions she suggests asking: What's included in in the costs, such as licensing for the index and the ESG data? How robust is the ESG data set? How does the optimizer replicate the index, and how does it manage taxes?

“Asking those questions is really important in terms of understanding what you actually will get with that particular direct index provider,” she said.