Direct indexing gains appeal as taxable losses mount

Technology platforms evolve quickly to give financial advisers tools to help clients mitigate the tax hit as financial markets decline.

Nobody likes investment losses, but for financial advisers looking to cushion the blow of the stock market downturn, direct indexing is quickly emerging as the right tool for the times.

“This is not something I even knew about three years ago, but now I think direct indexing will do for separately managed accounts what ETFs did for mutual funds,” said Chuck Failla, principal at Sovereign Financial Group. “It’s a very cool tool that allows us to create very customized portfolios in a very tax-efficient way.”

While the basic concept behind direct indexing has been around for decades in various forms, particularly among the institutional investor ranks, fast-evolving technology is driving adoption within the financial advisory universe.

In the most basic sense, direct indexing leverages technology to provide investors with direct exposure to the underlying securities that make up an index. Thus, instead of investing in the S&P 500 Index through something like the SPDR S&P 500 ETF (SPY), a direct index investment might involve directly owning 300 stocks representing a proxy of the larger index.

Among the biggest advantages of directing indexing — and by far the most popular use — is tax management, which is all automated by the various providers.

Jennifer Sireklove, managing director of investment strategy at Parametric, said tax management is the driving force, but investors and financial advisers are also drawn to the idea of being able to customize popular indexes.

“This is about the growth of passive investing and the appeal of being in the market instead of beating the market,” she said. “It’s about tax management and not being beholden to someone else’s definition of what the market is.”

Parametric, which is now owned by Morgan Stanley, is a top-tier player in the direct indexing space, but the space is getting crowded, which is expected to drive down costs.

“Years ago, this was just called tax-managed investing,” Sireklove said of what is now popularly referred to as direct indexing.

“When you look across our business, a large chunk is using indexes as is and really just going after the tax benefits,” she said. “But there can be some simple customizations that can get clients closer to where they want to be in terms of controlling geographic exposure, for example. Then it can get more complicated if working around concentrated stock positions, and it gets more nuanced and complicated from there.”

TAX ADVANTAGE

According to Cerulli Associates, direct indexing’s most quantifiable advantage is tax optimization and the resultant tax savings.

“Leading advisers view tax optimization as a unique and tangible value they can deliver to their clients,” Cerulli wrote in a recent report on the topic.

The report included results of an adviser survey that showed 48.4% of respondents saw ongoing tax optimization through direct indexing as a major opportunity, while 51.6% ranked it as a moderate opportunity.

On the topic of direct indexing tax management benefits for accounts that are transitioning, 35.5% of advisers ranked it as a major opportunity, and 42.5% ranked it as a moderate opportunity.

The next highest-ranking benefit of direct indexing was the ability to customize indexes for environmental, social and governance investing, with 16.1% of advisers ranking it as a major opportunity, and 38.7% ranking it as a moderate opportunity.

Beyond that, factor investing, thematic portfolios, and excluding industry sectors were all ranked as moderate opportunities for direct indexing.

GROWING FAST

The list of direct index providers is growing fast with such major asset management players as BlackRock buying direct indexer Aperio in November 2020, and Vanguard entering the space in July of 2021 through the acquisition of Just Invest.

Charles Schwab Corp. is a relative newcomer, having launched its direct indexing platform in April.

“It’s a newer foray for us, but we got into direct indexing in response to a lot of feedback we’ve been hearing from financial advisers,” said Jalina Kerr, managing director of adviser services at Schwab.

While direct indexing customization potential is expanding at a rapid clip, Schwab is taking a deliberate approach with just three offerings, initially.

Kerr said that offerings that include direct indexing access to a large-cap, small-cap and ESG index should be viewed as building blocks.

“The point we’re at is making sure we can support it,” she said. “We have every intention to support it more aggressively. We’re going to be offering more flexibility and additional enhancements before the end of the year.”

Schwab’s motivation to move into the space is no different than any other firm trying to hold on to assets in a technology-driven environment of constant creativity.

Jim Dilworth, co-founder of direct indexing platform Veriti Management, said the appeal of direct indexing is a natural extension of the momentum behind passive indexed investing.

“The technology is changing rapidly, allowing for the ability to develop these tech platforms and scale them,” he said. “For advisers and institutions that want exposure to any benchmark, the notion is you can provide the same exposure to an index or ETF with low tracking error to the index, and you can do tax-loss harvesting, you can customize, and you can align the portfolio to your values.”

With investment minimums typically set at around $100,000, the wealth management space is pouncing on a wide-open universe of individual accounts that could benefit from tax optimization through a direct indexing platform.

Even as the fees have been coming down in stride with growing competition, the 15 basis points that Schwab is charging is well above the typical index ETFs that offer broad market exposure for as little as 2 or 3 basis points.

“The DIY version is by far the most unique in the industry.”

Chris Romano, vice president of investment management technology, Orion

And some platforms, recognizing the importance of a financial intermediary to introduce investors to the concept of direct indexing, are making it easier for advisers to adjust the fees at the client level.

At Orion Advisor Solutions, the direct indexing platform can be brought in-house at an advisory firm for an annual fee of $50 per account, or it can be white-labeled or outsourced for between 20 and 25 basis points.

The do-it-yourself version, which was launched four years ago, requires an RIA to manage the accounts, said Chris Romano, Orion’s vice president of investment management technology.

“The DIY version is by far the most unique in the industry,” Romano said.

Failla, of Sovereign Financial Group, said he opted for the DIY version even though it costs an estimated $250,000 annually for the trader and technology required to run the accounts.

He offsets that cost by charging clients 20 basis points for the direct indexing service.

David Schneider, founder of Schneider Wealth Strategies, is also a fan of direct indexing for tax optimization purposes, but he said advisers and clients need to be weighing the added fees.

“Direct indexing offers more potential tax-loss harvesting opportunities than a conventional ETF or fund approach, although these benefits are probably overstated,” he said. “There’s a high degree of customization, so it can be a good strategy for investors who want to avoid exposure to specific companies or industries. But one of the downsides to direct indexing is potentially higher costs versus an ETF or index fund.”

PROS AND CONS

Tyler Martin, director of financial planning at Stonebridge Wealth Management, also cited the higher fees, compared with low-cost index funds, as a pill that clients have to swallow when it comes to direct indexing.

“As wealth managers serving high-net-worth and ultra-high-net-worth families, direct indexing enables wealthy clients to create tax optimal portfolios creating as much as 2% annually in tax alpha,” he said. “Direct indexing also means more effective charitable giving through the donation of handpicked appreciated securities. An often-overlooked benefit is the ability to customize the portfolio based on the client’s values. This means adjusting the holdings based on companies they do or do not want to support. But the primary drawbacks for direct indexing are higher fees.”