‘No detractor’ to using direct indexing as an investment strategy
Thirty four percent of advisors surveyed by InvestmentNews say they use direct indexing strategies but 39 percent don’t.
Despite the benefits and growing demand of direct indexing strategies, advisors seem to be a mixed bag on the matter, with many seemingly underutilizing them.
Recent survey research from InvestmentNews found that while 34 percent of survey respondents said they currently use or are planning to use direct indexing as an investment strategy, 39 percent said the opposite.
However, 28 percent said they will consider it in the future.
"This dovetails with the data I've seen, which shows very similar categories and percentages," said Brandon Thomas, co-founder and co-chief investment officer at Envestnet PMC.
He said the 62 percent of those either using or considering direct indexing represents a "pretty good percentage" given the strategy's relatively recent rise to prominence in the wealth management space.
However, Thomas acknowledged those with no plans to use direct indexing can mean a few different things. Some advisors prefer to utilize active managers, whether through actively managed separately managed account (SMAs) or mutual funds.
Others may cater to a client base with smaller account sizes, where the $100,000-plus minimums typical of direct indexing solutions may not align. Some are just unclear on the benefits.
“Direct indexing is a completely algorithmic, quantitative, optimized approach, and sometimes there's not an understanding of that approach. That can lead to misconceptions and a black box type of understanding,” Thomas said.
Some may underappreciate the customization and personalization benefits, which enable advisors to tailor portfolios to client preferences around factors and values, he said.
Tax optimization and tax loss harvesting opportunities are at the top of the list, as direct indexing's ownership of individual securities allows for greater flexibility in managing capital gains and losses.
“If I were an advisor, I would absolutely consider direct indexing,” he said. “It combines the best of all worlds.”
“For advisors who have clients that qualify for separate accounts, it's a SMA that can be customized and tax managed, and then you're getting low-cost asset class exposure with direct index solutions,” he said.
Index returns are the same as a traditional ETF, so clients aren't sacrificing performance. The key difference is the ability to control tax opportunities and capital loss, said Brad Morgan, wealth advisor at Savvy Advisors.
“Assuming performance is equivalent, assuming cost is equivalent, which, in our case, it is, there's really no detractor. The attraction is that you're able to control the capital gains process more delicately and specifically, increasing capital loss generation.”
When clients hear capital loss generation, Morgan said folks typically worry about increasing their loss of funds but “that's not the case.”
“We're actually accelerating realization of capital losses, but the index return is the same. There’s no loss in return with the capture of loss, it's just a decrease in the cost basis of the account.”
One of the biggest misconceptions in direct indexing is understanding how losses can be captured while continuing to get positive returns year in and year out or returns of an index, he added.
Meanwhile, some advisors said direct indexing has added value for clients and is a core component of their firms' portfolios and planning.
“The continual tax loss harvesting these strategies offer can help diversify a client's portfolio over time, while accounting for and controlling the tax impact of realizing potential gains. Direct indexing also offers an advisor the ability to customize a client's portfolio to reflect their preferences on dimensions like ESG or thematic investing,” said Steve Dean, CIO at Compound Planning, in an email.
Costs of direct indexing strategies have come down as competition has increased, resulting in strategies that are attractive relative to the expense ratios in ETF or mutual fund portfolios that many firms offer, as the direct-indexed accounts are generally using individual securities, he added.
While there aren’t any particular drawbacks unique to direct indexing compared to other approaches that hold individual securities like individual stock picking or SMAs, the amount of tax losses harvested can slow as the underlying securities appreciate, said Jason D. Hendricks, director and portfolio manager at Crestwood Advisors.
“There are a variety of ways to mitigate that, but the bottom line is that strategies like direct indexing, which offer a tax benefit along with intelligent market participation, are a win for investors,” he said in an email. “We expect demand and utilization will only increase over time.”
“It's one of those things that [advisors are] going to have to use,” Morgan said. “When the competition is using it, and you're not, people are going to have to step into that end of the arena.”
The datasets come from 126 advisors surveyed among several RIAs and broker-dealers.
Meet
Brad Morgan
Hi there! 👋🏼 I'm Brad, a former Procter & Gamble employee turned financial advisor. With a focus on tax planning, I've been a trusted advisor for the P&G community for over ten years.
‘No detractor’ to using direct indexing as an investment strategy
Thirty four percent of advisors surveyed by InvestmentNews say they use direct indexing strategies but 39 percent don’t.
Despite the benefits and growing demand of direct indexing strategies, advisors seem to be a mixed bag on the matter, with many seemingly underutilizing them.
Recent survey research from InvestmentNews found that while 34 percent of survey respondents said they currently use or are planning to use direct indexing as an investment strategy, 39 percent said the opposite.
However, 28 percent said they will consider it in the future.
"This dovetails with the data I've seen, which shows very similar categories and percentages," said Brandon Thomas, co-founder and co-chief investment officer at Envestnet PMC.
He said the 62 percent of those either using or considering direct indexing represents a "pretty good percentage" given the strategy's relatively recent rise to prominence in the wealth management space.
However, Thomas acknowledged those with no plans to use direct indexing can mean a few different things. Some advisors prefer to utilize active managers, whether through actively managed separately managed account (SMAs) or mutual funds.
Others may cater to a client base with smaller account sizes, where the $100,000-plus minimums typical of direct indexing solutions may not align. Some are just unclear on the benefits.
“Direct indexing is a completely algorithmic, quantitative, optimized approach, and sometimes there's not an understanding of that approach. That can lead to misconceptions and a black box type of understanding,” Thomas said.
Some may underappreciate the customization and personalization benefits, which enable advisors to tailor portfolios to client preferences around factors and values, he said.
Tax optimization and tax loss harvesting opportunities are at the top of the list, as direct indexing's ownership of individual securities allows for greater flexibility in managing capital gains and losses.
“If I were an advisor, I would absolutely consider direct indexing,” he said. “It combines the best of all worlds.”
“For advisors who have clients that qualify for separate accounts, it's a SMA that can be customized and tax managed, and then you're getting low-cost asset class exposure with direct index solutions,” he said.
Index returns are the same as a traditional ETF, so clients aren't sacrificing performance. The key difference is the ability to control tax opportunities and capital loss, said Brad Morgan, wealth advisor at Savvy Advisors.
“Assuming performance is equivalent, assuming cost is equivalent, which, in our case, it is, there's really no detractor. The attraction is that you're able to control the capital gains process more delicately and specifically, increasing capital loss generation.”
When clients hear capital loss generation, Morgan said folks typically worry about increasing their loss of funds but “that's not the case.”
“We're actually accelerating realization of capital losses, but the index return is the same. There’s no loss in return with the capture of loss, it's just a decrease in the cost basis of the account.”
One of the biggest misconceptions in direct indexing is understanding how losses can be captured while continuing to get positive returns year in and year out or returns of an index, he added.
Meanwhile, some advisors said direct indexing has added value for clients and is a core component of their firms' portfolios and planning.
“The continual tax loss harvesting these strategies offer can help diversify a client's portfolio over time, while accounting for and controlling the tax impact of realizing potential gains. Direct indexing also offers an advisor the ability to customize a client's portfolio to reflect their preferences on dimensions like ESG or thematic investing,” said Steve Dean, CIO at Compound Planning, in an email.
Costs of direct indexing strategies have come down as competition has increased, resulting in strategies that are attractive relative to the expense ratios in ETF or mutual fund portfolios that many firms offer, as the direct-indexed accounts are generally using individual securities, he added.
While there aren’t any particular drawbacks unique to direct indexing compared to other approaches that hold individual securities like individual stock picking or SMAs, the amount of tax losses harvested can slow as the underlying securities appreciate, said Jason D. Hendricks, director and portfolio manager at Crestwood Advisors.
“There are a variety of ways to mitigate that, but the bottom line is that strategies like direct indexing, which offer a tax benefit along with intelligent market participation, are a win for investors,” he said in an email. “We expect demand and utilization will only increase over time.”
“It's one of those things that [advisors are] going to have to use,” Morgan said. “When the competition is using it, and you're not, people are going to have to step into that end of the arena.”
The datasets come from 126 advisors surveyed among several RIAs and broker-dealers.
Meet
Brad Morgan
Hi there! 👋🏼 I'm Brad, a former Procter & Gamble employee turned financial advisor. With a focus on tax planning, I've been a trusted advisor for the P&G community for over ten years.
