Displaying items by tag: direct indexing

Direct indexing has been around for 30 years but was once only accessible and viable for ultra-high net-worth investors. Now, technology and lower transaction costs have made it available for a much wider swath of investors who are able to benefit from direct indexing’s tax-loss harvesting and customization abilities.

Interestingly, the strategy is finding particular favor among millennial investors who are interested in tax optimization and personalization which are not possible through traditional passive investing. Advisors can customize holdings in a way that reflects a client’s values and preferences such as prioritizing ESG criteria or adjusting a portfolio based on a client’s risk profile. Holdings can also be customized to account for a clients’ unique financial situation, which is also not possible through investing in ETFs or mutual funds. 

For advisors, it presents an opportunity to differentiate themselves in a competitive landscape by offering personalized and optimized solutions. Direct indexing is likely to continue growing as it’s becoming increasingly available through many online brokerages and wealth management firms. It’s also consistent with many younger investors’ desired preference to have their personal holdings reflect their values and beliefs. 

Finsum: Direct indexing is growing at a rapid pace, and it’s finding favor with Millennial investors due to its tax optimization and personalization.  

According to a report from Cerulli Associates, direct indexing will grow faster than ETFs, mutual funds, and separately managed accounts (SMA) over the next 5 years. Currently, it’s estimated that total assets under management for direct indexing strategies will exceed $800 billion by 2026 from $462 billion at the beginning of last year. 

Another factor that should support direct indexing’s growth is that only 14% of financial advisors are aware of direct indexing and actively recommend it to clients. It’s estimated that 63% of advisors have a client with over $500,000 in investable assets, while 14% of advisors focus on clients with over $5 million in assets. Direct indexing offers the most clear advantages for high net worth clients. For advisors, it’s an opportunity to offer a differentiated service especially as tax management and customization are highly valued by many prospects. 

Direct indexing is growing in popularity as it allows investors to retain the major benefits of index investing while accessing greater personalization and unlocking certain tax advantages. With direct indexing, clients own the actual components of an index as opposed to an ETF or mutual fund. This leads to more potential for tax loss harvesting and customization to suit a clients’ particular needs or construct a portfolio that aligns with their values. 

Finsum: Direct indexing is forecast to grow faster than many ETFs, mutual funds, and SMAs over the next 5 years. Here are some of the key reasons for its growth, and why advisors should pay attention.  

One of the major benefits of direct indexing is that tax losses can be harvested during up and down years. This option is not available to clients who are invested in indices. This is because clients will own the actual components of an index in their account rather than an ETF or a mutual fund. With regular scans, losing positions can be sold to harvest tax losses which can then be used to offset gains in the future or other parts of the portfolio.

This is because some components of the index will be in the red even in up years. These positions are sold and then other stocks with similar factor scores are added to ensure the benchmark continues to be tracked. 

According to Vanguard, “Because investors directly own the individual securities in their direct indexing portfolios, you can harvest losses for them even in years when the index is up. You can use these losses to offset your clients’ capital gains, and help them keep more of what their portfolios earn.” Overall, it believes that the strategy can add between 1% and 2% in annual returns in after-tax alpha for clients with large capital gains in addition to helping optimize short and long-term holding periods to minimize capital gains taxes. 

Finsum: Direct indexing has several benefits for investors such as tax-loss harvesting. While many are familiar with its application during down years, less are aware that it can be used to add alpha even in up years. 

For many clients who want personalized solutions and have complicated financial needs, the traditional approach of mutual funds or ETFs fall short. For investors with more complex tax issues or who desire that their investments align with their values, direct indexing offers a more comprehensive strategy.

Direct indexing captures many of the benefits of passive investing such as diversification, low-costs, and investing in an index. But the key differences are that the actual components of an index are owned by the investor rather than the fund. 

Thus, there is a greater level of customization as investors modify these holdings to reflect their own political, religious, or ethical beliefs. This is especially pertinent with the increasing traction of ESG or values-based investing. 

This customization can lead to better risk management as portfolios can be adjusted to reflect a clients’ particular risk profile and long-term goals. Another benefit is increased tax efficiency as there is more control over when capital gains are realized. Tax losses can be regularly harvested and used to offset capital gains. Similarly, charitable giving through direct indexing can also have certain tax advantages while also giving clients an opportunity to support causes or organizations that they believe in. 

Finsum: Direct indexing has specific benefits that may appeal to clients looking to optimize their tax situation, align their investment with their values, while still retaining the benefits of passive investing. 

Advisors can use direct indexing to optimize their clients’ portfolios, reduce tax bills, and offer more customized solutions. It also offers an opportunity for an advisor to differentiate themselves and increase their appeal to high net worth prospects with specific needs.

Direct indexing offers more flexibility and solutions than traditional passive investing while retaining the major benefits. One example is that it can be used to reduce concentrated stock positions in a manner that can offset capital gains taxes and help lead to a more diversified and balanced long-term portfolio.

With direct indexing, tax losses can be harvested and set aside. This effectively turns them into assets which isn’t possible with investing in index funds. It could be especially of value to clients expecting a future financial windfall who are interested in proactive steps to reduce the future tax burden. 

Indices can also be modified to offset a large allocation to a specific stock or sector in another part of the portfolio. For instance, someone who works in the tech industry with a large number of stock options may not want tech exposure in their personal portfolio. 

Advisors can start this conversation with prospects by discussing matters like future windfalls, concentrated positions, reducing capital gains taxes, and more personalized solutions.

Finsum: Direct indexing is a way to optimize clients’ portfolios especially those with large capital gains taxes, concentrated positions, and expectations of a future financial windfall.