Is direct indexing really new or special?

Direct indexing is one of the hotter segments of the retail financial services industry, with assets expected to grow by more than 12% annually over the next five years, according to a recent report by Cerulli Associates. Today direct indexing assets account for nearly one-fifth of total retail separate account assets, with some $362 billion in assets.

Direct indexing allows retail investors to own indexed assets directly so that they pay capital gains taxes only on gains that they personally have benefited from (unlike investing in some ETFs or mutual funds, where gains from prior years may be embedded in share prices, and indices are not always tracked precisely). As I dig into this trend, direct indexing looks, smells and tastes a lot like something that’s been around for decades: separately managed accounts. Advances in technology — and the ability to trade fractional shares — have made this approach even more attractive in recent years. 

Like direct indexed portfolios, SMAs can be readily customized to specific client needs. Say your client owns decades’ worth of incentive pay in Microsoft stock — and she’d like an S&P 500 or tech portfolio that excludes that particular holding. An SMA can accomplish that goal just as easily as direct indexing.

Or imagine that you have a client with very particular ESG concerns. He wants to emphasize green power, but he includes in that category nuclear power, which is excluded from many ETFs and their underlying indices. An SMA portfolio can fine-tune his exposure in that way. 

Like a direct indexed portfolio, an SMA provides investors with direct ownership of a portfolio of securities. This provides the same tax advantages as direct indexing. However, SMAs may provide more control and flexibility.

That starts with the mindset that advisors and their clients are not limited to just picking an index and tinkering with it. They can customize an existing benchmark to their requirements or construct an entirely new one. That flexibility empowers advisors to differentiate themselves by really getting into the nuts and bolts of portfolio management: researching index constituents, selecting new ones, understanding rebalancing and gaining a nuanced picture of the effect of equal versus cap-weighting. That can impress larger clients, and perhaps be “sticky” during wealth transfers to the next generation.

Advisors can seek enhanced performance by building a rules-based tactical component to their client’s portfolios, for instance automatically switching in and out of that index depending on valuations, momentum or any other market indicator. It’s also fairly straightforward to add an options strategy to generate income if this is what your client requires. ESG screening criteria can be readily customized, for example, focusing on environmental factors or social factors exclusively. Advisors and their clients can make their own rules and choose the exposures that best fit their needs. 

Technology and advances in advisory platforms have made it far easier to run SMA portfolios than it used to be. I manage my daughter’s accounts this way using an online platform. Motif Investing, purchased by Schwab, and FolioFN, purchased by Interactive Brokers, also created tools for creating customized index portfolios. 

By developing expertise in SMA management, advisors can create categories that don’t currently exist in the market — and calibrate client portfolios precisely to their individual needs and objectives. It can be a practice differentiator, perhaps capturing the attention of the next generation before assets are passed down. It can be an entry point into asset management, perhaps your product is the next ETF. It can be seeded with your own clients’ assets. 

Direct indexing may be the rage of the moment, but for me, it is another form of SMAs. I believe SMAs will not go out of style, and they may truly make a difference in building your practice and your client’s desired outcomes. 

Andrew Corn heads E5A Integrated Marketing, a systematic, data-driven investor acquisition agency, and is a former CIO and ETF designer.