Direct Indexing vs. Active Management: Which Approach is Best for High Net Worth Portfolios?
As a financial advisor, one of the most important decisions is determining the optimal investment approach to meet each client's unique goals and preferences. Two popular strategies that have gained traction in recent years are direct indexing and active portfolio management. In this post, we'll take an in-depth look at the key differences between these approaches and explore which one may be most suitable for affluent investors.
The Appeal of Direct Indexing for High Net Worth Clients
Direct indexing has emerged as an attractive option for high net worth investors due to its ability to provide index-like returns with enhanced customization, tax efficiency, and transparency compared to traditional index funds or ETFs.
With direct indexing, investors own the individual securities that comprise an index, rather than owning shares of a pooled vehicle. This allows for the portfolio to be tailored to the client's specific needs and preferences. For example:
Values-based customization: Clients can exclude companies or industries that don't align with their values, such as fossil fuels, tobacco, or weapons manufacturers. Conversely, they can tilt the portfolio toward companies with strong records on environmental, social and governance (ESG) issues.[2][8]
Tax optimization: Direct indexing enables tax-loss harvesting at the individual security level. By realizing losses to offset gains elsewhere in the portfolio, clients can potentially boost their after-tax returns. This "tax alpha" can be especially impactful for high net worth investors in high tax brackets.[1][3][11]
Concentrated stock positions: For clients with large holdings in a single stock, direct indexing provides a way to diversify around that position in a tax-efficient manner. The portfolio can be optimized to minimize overexposure to the concentrated holding's sector or risk factors.[9][14]
Charitable giving: Because clients hold the individual securities, they have the flexibility to donate highly appreciated shares to charity. This can provide a larger tax deduction than donating cash, while also avoiding capital gains taxes on the shares.[4]
Several major asset managers and fintechs have launched direct indexing offerings in recent years to capitalize on this growing demand from high net worth investors. Cerulli Associates estimates that total direct indexing assets reached $434 billion by the end of 2022, with a projected growth rate of 12% annually through 2026 - outpacing mutual funds and ETFs.[14]
The Case for Active Management
While direct indexing offers compelling benefits, traditional active management still plays an important role in many high net worth portfolios. Skilled active managers have the potential to outperform passive benchmarks by exploiting market inefficiencies and adapting to changing market conditions.
Some of the key advantages of active management include:
Alpha generation: Active managers may be able to deliver excess returns over the benchmark index through superior security selection and/or tactical asset allocation. Although the majority of active funds underperform net of fees, a select group of managers has demonstrated the ability to consistently generate alpha over long time horizons.[12][19]
Downside protection: Active managers have the flexibility to defensively position the portfolio and mitigate losses during market corrections. By underweighting or avoiding overvalued sectors and securities, skilled managers can provide a smoother ride for clients, which is especially valuable for retirees or those with shorter time horizons.[8][11]
Differentiated strategies: Boutique active managers often employ niche strategies that aren't easily replicated by passive vehicles. This can include focused portfolios, alternative assets, or factor-based approaches. For clients seeking to complement their core holdings and potentially boost risk-adjusted returns, these types of differentiated strategies can be attractive.[13][19]
Personal touch: Some high net worth clients simply prefer to have a portion of their assets actively managed by a seasoned professional with whom they have a personal relationship. Active managers can incorporate clients' unique circumstances and provide a higher level of customization and responsiveness than a purely passive approach.[8]
Of course, active management does have some notable drawbacks, including higher costs, less transparency, and manager risk. Clients must be comfortable with the potential for both outperformance and underperformance relative to the benchmark.[12]
Combining Direct Indexing and Active Management in a Core-Satellite Approach
For many high net worth investors, the optimal solution may be a core-satellite approach that combines the benefits of direct indexing and active management.
The core of the portfolio would consist of a direct indexed strategy tracking a broad market index like the S&P 500. This provides low-cost, tax-efficient exposure to the market, with the ability to customize the holdings and harvest losses.[11]
Actively managed strategies are then used as satellites around the core to target specific objectives such as generating alpha, reducing volatility, or gaining exposure to alternatives and private markets. Because the core is so efficient, clients can allocate more of their risk budget to high-conviction active managers.[11]
This core-satellite approach using direct indexing has the potential to boost after-tax returns. The tax losses generated in the core can be used to offset gains produced by the active managers in the satellites. And with less assets needed to fund the satellites, there is greater capacity to hold appreciated securities in the core for the long-term, further deferring taxes.[11]
Choosing the Right Approach for Each Client
Ultimately, the decision between direct indexing and active management (or a combination of the two) depends on each client's unique circumstances, goals and preferences. As a financial advisor, it's our role to understand what's most important to our clients and build portfolios accordingly.
Factors to consider include:
Liquidity needs: Clients with substantial near-term income needs may prefer the simplicity and predictability of direct indexing. Those with longer time horizons may be able to accept the greater variability of active strategies in pursuit of higher returns.[3]
Tax sensitivity: The higher a client's tax bracket, the more they stand to benefit from direct indexing's tax-loss harvesting capabilities. However, it's important to balance this against their other goals and the tracking error that can result from aggressively harvesting losses.[1][4]
Desire for customization: If a client has strong views on ESG issues or other preferences, direct indexing provides the flexibility to tailor the portfolio to match. More hands-off clients may be content with a purely active approach.[2][8]
Risk tolerance: Clients who are more risk-averse may appreciate the tighter tracking error and transparency of direct indexing. Those with a higher risk appetite might prefer the potential for outperformance with active management, even if it comes with greater uncertainty.[12][19]
Cost sensitivity: All else equal, direct indexing tends to be more cost-effective than active management, especially at higher asset levels. Clients who are particularly fee-conscious may gravitate toward direct indexing.[3]
By taking the time to understand each client's individual needs and educating them on the tradeoffs of each approach, advisors can construct portfolios that are optimally positioned to help clients achieve their financial objectives.
Looking Ahead
As direct indexing technology continues to improve and costs come down, we expect this approach to become accessible to a broader swath of investors in the coming years. According to a recent PwC survey, nearly 40% of institutional investors plan to invest in custom indexing products in the next 12-24 months, while almost half of asset managers expect to add direct indexing solutions to their lineup.[15]
At the same time, active management is far from dead. PwC projects that private markets and alternative investments will drive nearly half of asset management industry revenues by 2027, as investors seek out differentiated sources of return in an increasingly efficient public market environment.[15]
The most successful advisors will likely be those who can effectively harness both direct indexing and active management to build highly customized solutions for their high net worth clients. By combining the precision and efficiency of indexing with the potential alpha of skilled active managers, advisors can deliver significant value to clients and deepen relationships for the long-term.
References
In summary, direct indexing offers high net worth investors an attractive combination of customization, tax efficiency and transparency, while active management provides the potential for outperformance through security selection and tactical positioning. By thoughtfully combining these approaches in a core-satellite framework, advisors can build highly tailored portfolios designed to help wealthy clients achieve their long-term financial goals. As the investment landscape continues to evolve, those who can successfully harness the power of both indexing and active management will be well-positioned to grow their businesses and deliver significant value to clients.
Material prepared herein has been created for informational purposes only and should not be considered investment advice or a recommendation. Information was obtained from sources believed to be reliable but was not verified for accuracy. It is important to note that federal tax laws under the Internal Revenue Code (IRC) of the United States are subject to change, therefore it is the responsibility of taxpayers to verify their taxation obligations.
Savvy Wealth Inc. is a technology company. Savvy Advisors, Inc. is an SEC registered investment advisor. For purposes of this article, Savvy Wealth and Savvy Advisors together are referred to as “Savvy”. All advisory services are offered through Savvy Advisors, while technology is offered through Savvy Wealth. The views and opinions expressed herein are those of the speakers and authors and do not necessarily reflect the views or positions of Savvy Advisors.
Direct Indexing vs. Active Management: Which Approach is Best for High Net Worth Portfolios?
As a financial advisor, one of the most important decisions is determining the optimal investment approach to meet each client's unique goals and preferences. Two popular strategies that have gained traction in recent years are direct indexing and active portfolio management. In this post, we'll take an in-depth look at the key differences between these approaches and explore which one may be most suitable for affluent investors.
The Appeal of Direct Indexing for High Net Worth Clients
Direct indexing has emerged as an attractive option for high net worth investors due to its ability to provide index-like returns with enhanced customization, tax efficiency, and transparency compared to traditional index funds or ETFs.
With direct indexing, investors own the individual securities that comprise an index, rather than owning shares of a pooled vehicle. This allows for the portfolio to be tailored to the client's specific needs and preferences. For example:
Values-based customization: Clients can exclude companies or industries that don't align with their values, such as fossil fuels, tobacco, or weapons manufacturers. Conversely, they can tilt the portfolio toward companies with strong records on environmental, social and governance (ESG) issues.[2][8]
Tax optimization: Direct indexing enables tax-loss harvesting at the individual security level. By realizing losses to offset gains elsewhere in the portfolio, clients can potentially boost their after-tax returns. This "tax alpha" can be especially impactful for high net worth investors in high tax brackets.[1][3][11]
Concentrated stock positions: For clients with large holdings in a single stock, direct indexing provides a way to diversify around that position in a tax-efficient manner. The portfolio can be optimized to minimize overexposure to the concentrated holding's sector or risk factors.[9][14]
Charitable giving: Because clients hold the individual securities, they have the flexibility to donate highly appreciated shares to charity. This can provide a larger tax deduction than donating cash, while also avoiding capital gains taxes on the shares.[4]
Several major asset managers and fintechs have launched direct indexing offerings in recent years to capitalize on this growing demand from high net worth investors. Cerulli Associates estimates that total direct indexing assets reached $434 billion by the end of 2022, with a projected growth rate of 12% annually through 2026 - outpacing mutual funds and ETFs.[14]
The Case for Active Management
While direct indexing offers compelling benefits, traditional active management still plays an important role in many high net worth portfolios. Skilled active managers have the potential to outperform passive benchmarks by exploiting market inefficiencies and adapting to changing market conditions.
Some of the key advantages of active management include:
Alpha generation: Active managers may be able to deliver excess returns over the benchmark index through superior security selection and/or tactical asset allocation. Although the majority of active funds underperform net of fees, a select group of managers has demonstrated the ability to consistently generate alpha over long time horizons.[12][19]
Downside protection: Active managers have the flexibility to defensively position the portfolio and mitigate losses during market corrections. By underweighting or avoiding overvalued sectors and securities, skilled managers can provide a smoother ride for clients, which is especially valuable for retirees or those with shorter time horizons.[8][11]
Differentiated strategies: Boutique active managers often employ niche strategies that aren't easily replicated by passive vehicles. This can include focused portfolios, alternative assets, or factor-based approaches. For clients seeking to complement their core holdings and potentially boost risk-adjusted returns, these types of differentiated strategies can be attractive.[13][19]
Personal touch: Some high net worth clients simply prefer to have a portion of their assets actively managed by a seasoned professional with whom they have a personal relationship. Active managers can incorporate clients' unique circumstances and provide a higher level of customization and responsiveness than a purely passive approach.[8]
Of course, active management does have some notable drawbacks, including higher costs, less transparency, and manager risk. Clients must be comfortable with the potential for both outperformance and underperformance relative to the benchmark.[12]
Combining Direct Indexing and Active Management in a Core-Satellite Approach
For many high net worth investors, the optimal solution may be a core-satellite approach that combines the benefits of direct indexing and active management.
The core of the portfolio would consist of a direct indexed strategy tracking a broad market index like the S&P 500. This provides low-cost, tax-efficient exposure to the market, with the ability to customize the holdings and harvest losses.[11]
Actively managed strategies are then used as satellites around the core to target specific objectives such as generating alpha, reducing volatility, or gaining exposure to alternatives and private markets. Because the core is so efficient, clients can allocate more of their risk budget to high-conviction active managers.[11]
This core-satellite approach using direct indexing has the potential to boost after-tax returns. The tax losses generated in the core can be used to offset gains produced by the active managers in the satellites. And with less assets needed to fund the satellites, there is greater capacity to hold appreciated securities in the core for the long-term, further deferring taxes.[11]
Choosing the Right Approach for Each Client
Ultimately, the decision between direct indexing and active management (or a combination of the two) depends on each client's unique circumstances, goals and preferences. As a financial advisor, it's our role to understand what's most important to our clients and build portfolios accordingly.
Factors to consider include:
Liquidity needs: Clients with substantial near-term income needs may prefer the simplicity and predictability of direct indexing. Those with longer time horizons may be able to accept the greater variability of active strategies in pursuit of higher returns.[3]
Tax sensitivity: The higher a client's tax bracket, the more they stand to benefit from direct indexing's tax-loss harvesting capabilities. However, it's important to balance this against their other goals and the tracking error that can result from aggressively harvesting losses.[1][4]
Desire for customization: If a client has strong views on ESG issues or other preferences, direct indexing provides the flexibility to tailor the portfolio to match. More hands-off clients may be content with a purely active approach.[2][8]
Risk tolerance: Clients who are more risk-averse may appreciate the tighter tracking error and transparency of direct indexing. Those with a higher risk appetite might prefer the potential for outperformance with active management, even if it comes with greater uncertainty.[12][19]
Cost sensitivity: All else equal, direct indexing tends to be more cost-effective than active management, especially at higher asset levels. Clients who are particularly fee-conscious may gravitate toward direct indexing.[3]
By taking the time to understand each client's individual needs and educating them on the tradeoffs of each approach, advisors can construct portfolios that are optimally positioned to help clients achieve their financial objectives.
Looking Ahead
As direct indexing technology continues to improve and costs come down, we expect this approach to become accessible to a broader swath of investors in the coming years. According to a recent PwC survey, nearly 40% of institutional investors plan to invest in custom indexing products in the next 12-24 months, while almost half of asset managers expect to add direct indexing solutions to their lineup.[15]
At the same time, active management is far from dead. PwC projects that private markets and alternative investments will drive nearly half of asset management industry revenues by 2027, as investors seek out differentiated sources of return in an increasingly efficient public market environment.[15]
The most successful advisors will likely be those who can effectively harness both direct indexing and active management to build highly customized solutions for their high net worth clients. By combining the precision and efficiency of indexing with the potential alpha of skilled active managers, advisors can deliver significant value to clients and deepen relationships for the long-term.
References
In summary, direct indexing offers high net worth investors an attractive combination of customization, tax efficiency and transparency, while active management provides the potential for outperformance through security selection and tactical positioning. By thoughtfully combining these approaches in a core-satellite framework, advisors can build highly tailored portfolios designed to help wealthy clients achieve their long-term financial goals. As the investment landscape continues to evolve, those who can successfully harness the power of both indexing and active management will be well-positioned to grow their businesses and deliver significant value to clients.
Material prepared herein has been created for informational purposes only and should not be considered investment advice or a recommendation. Information was obtained from sources believed to be reliable but was not verified for accuracy. It is important to note that federal tax laws under the Internal Revenue Code (IRC) of the United States are subject to change, therefore it is the responsibility of taxpayers to verify their taxation obligations.
Savvy Wealth Inc. is a technology company. Savvy Advisors, Inc. is an SEC registered investment advisor. For purposes of this article, Savvy Wealth and Savvy Advisors together are referred to as “Savvy”. All advisory services are offered through Savvy Advisors, while technology is offered through Savvy Wealth. The views and opinions expressed herein are those of the speakers and authors and do not necessarily reflect the views or positions of Savvy Advisors.
