If you have been following the wealth management industry for several years, you have heard of direct indexing. It is not a new product, but when brokerage platforms eliminated equity trading commissions in the late 2010s, it lowered the barriers to entry for advisors and their clients. What was once a product reserved for the ultra-high net worth is now addressable to a much wider audience.
As an ETF product manager, I saw these changes firsthand. All the ways I had traditionally positioned ETFs had started to erode. ETFs are low-cost, but so are direct index accounts. ETFs have low minimums, but so does direct indexing. ETFs are tax-efficient, but direct indexing can be more tax-advantaged. ETFs are professionally managed, but so is direct indexing. The list went on.
Over several years, I sought out answers to the questions I needed to build conviction in direct indexing as an investment product. What is it? What are the use cases? What type of investor benefits most? And what should an advisor consider when deciding if and how to roll this out to their practice?
I debated direct indexing with my colleagues and the role that it would play in the future of wealth management. I concluded that, like ETFs before, the investment case for direct indexing was compelling and grounded in thoughtful investment research.
I have had the opportunity to discuss direct indexing with hundreds of financial advisors and read and conduct primary research on direct indexing. These have given me insight into how direct indexing can be used and how leading advisory firms have incorporated the the product into their practices.
Through this blog, I have consolidated and shared what I have seen and learned in building direct indexing products over the past four years.
A mentor once shared: “When doing something, it’s important to leave the woodpile higher than you found it.” I hope that what I have learned will be helpful for those looking at direct indexing for the first time or those who are already knowledgeable and interested in going deeper.
The Artist Formerly Known as Direct Indexing
A good place to start is to discuss what direct indexing is and what is not.
This is a basic question, but it is an important place to start because of how the industry has defined direct indexing.
When discussing direct indexing, many advisors have a preconceived notion that the product is only for passive strategies or indices.
And that is understandable. It’s literally called direct indexing.
In reality, however, direct indexing is not limited to indexing. The product can run various strategies, including factors, quantitative active, and fundamental active.
At its core, direct indexing is a separately managed account that uses portfolio management tools and practices historically reserved for large institutional accounts to provide bespoke portfolio customizations and tax management to each account.
These tools, called portfolio optimizers, use large datasets, complicated math, and statistical analysis to construct portfolios that mimic a target strategy’s return profile. That target can be a market cap-weighted index like the S&P 500 or a high-conviction, fundamental equity strategy holding 30 positions.
For now, the industry has coined the name direct indexing for the product. But, it is helpful to remember that the customization and tax management benefits can be applied to any investing strategy, not just passive.
The truth on direct indexing use cases
A general rule of thumb in investing is that if there is a good investment opportunity, the ultra-high net worth will likely be the first to figure it out. Direct indexing is no different.
A hint at the value and personalization that can be unlocked by investing directly in securities is that ultra-high-net-worth investors have been using some form of direct indexing for decades.
The primary reasons an investor would consider direct indexing over ETFs or mutual funds are:
- Improve tax efficiency: Direct indexing provides more opportunities to tax loss harvest a portfolio than ETFs and mutual funds. These additional capital losses can offset capital gains and up to $3,000 of ordinary income every year. Alternatively, the losses can be banked and carried forward to use in future years.
- Build around existing positions: Direct indexing can build portfolios around securities that cannot be sold (e.g., restricted stock, highly appreciated gains), improving overall portfolio diversification.
- Transition portfolios: Advisors can build around existing positions when transitioning a portfolio, reducing a client’s upfront tax bill.
- Express values or preferences: Constructing a portfolio with individual stocks allows advisors to apply custom values-based screens (e.g., religious values, ESG) to any investment strategy.
From my experience, these reasons are listed in the most common order of priority for advisors. Tax efficiency is the most commonly used use case and tends to be the most important and compelling for investors. This is followed by building portfolios around existing holdings and tax-aware portfolio transitions. Values-based investing is less widely used, except in cases where an advisor is a values-based investing specialist.
A note on taxes and the value of tax-loss harvesting
Since tax-loss harvesting is the most commonly used and arguably the most valuable use case for direct indexing, It is worth discussing it briefly. That said, if the mechanics of tax-loss harvesting sounds like something that will put you to sleep, feel free to jump to the next section.
The best way to conceptualize direct indexing tax-loss harvesting is as a capital loss-generating accelerator. Picture a nice fire burning in the backyard. This is your portfolio of ETFs or mutual funds that you tax loss harvest a few times a year.
Now, picture that fire if you poured a can of diesel on it. (Please don’t actually try this.) That’s the general idea of what direct indexing tax-loss harvesting does to a client’s portfolio. It radically increases the capital losses that can be generated from the account.
The source of this is the two principal types of portfolio volatility that allow us to tax loss harvest a security: time series volatility and cross-sectional volatility.
Time series volatility is the volatility that comes from a stock moving up and down over time. This is the tax-loss harvesting that both ETFs and direct indexing can capture. The security price falls from the purchase price, and we can sell it at a loss.
Cross-sectional volatility is the source of volatility unique to direct indexing. The general idea is that stocks are not perfectly correlated, so on any given day, some stocks are up, and some are down. In an ETF portfolio, we can only tax loss harvest the ETF position if all the stocks the ETF holds are down in aggregate. With direct indexing, however, because we own the stocks directly, we can sell the losers on any given day from the strategy and book a loss, even if the entire portfolio is at an aggregate gain.
Research shows that this excess source of capital loss generation allows direct indexing portfolios to generate consistently better after-tax returns than ETF portfolios.
That said, when evaluating the value for your client, you need to consider their specific capital gain profile because capital losses alone are not valuable. They need something to offset.
A great direct indexing client looks like…
While direct indexing can be a powerful tool for the right clients, it is not a one-size-fits-all solution. Specific characteristics will make investors a better fit for the product:
- Taxable assets: This is obvious, but I am listing it anyway. For a client to get the value of tax-loss harvesting, they must have taxable assets to invest.
- In the accumulation phase: The best clients for direct indexing are in the accumulation stage. These clients refresh their accounts with new tax lots and have time to accrue capital losses. Clients near or already in decumulation likely have significant embedded capital gains and negative cash flows.
- Tax bracket: The higher a client’s tax bracket, the more valuable tax avoidance. Ultra-high-net-worth investors benefit most significantly, but high-net-worth and mass-affluent clients can also benefit.
- Presence of or expectation for capital gains: Capital losses are only helpful when they have something to offset. While investors can offset $3,000 of ordinary income, the presence or expectation of capital gains increases the value of tax-loss harvesting.
- Locked-up holdings: A client with locked-up portfolio holdings such as restricted company stock or significant embeded gains.
- Comfort with more sophisticated investments: Direct indexing is a more sophisticated investment product than an ETF portfolio. Specific clients will appreciate the sophistication, while others may prefer the more basic portfolio of ETFs.
- Desire to align values with their investments: A client strongly desires to align their investments with personal values.
Acknowledging instances where direct indexing is not a good fit is also essential. Suppose a client has significant embedded capital gains and limited expectations of future cash flows. In that case, it is unlikely that realizing gains to switch to direct indexing will be productive.
Further, specific asset classes such as emerging market equities, investment strategies such as high-frequency trading, and strategies that rely heavily on futures, forwards, swaps, or options are less suited to direct indexing.
Is direct indexing right for my practice?
The largest and most sophisticated financial advisor firms have been the quickest to add and expand the use of direct indexing in client portfolios. These firms see the product as a way to further differentiate their services, improve client outcomes, and streamline their trading operations.
Speaking about their decision to expand direct indexing, a multi-billion dollar registered investment advisor shared:
“Direct indexing allows our clients to do all sorts of interesting things by owning shares individually. They can:
- Tax loss harvest very efficiently;
- Eliminate overconcentration in sectors related to their income;
- Tilt holdings towards specific factors (value, small-cap, etc.);
- Remove companies from their portfolios that do not reflect their personal values.
We have a substantial amount of capital in direct indexing… “
The sentiments this firm shared are not unique, and as I continue to meet with firms, I hear them shared more often.
Firms are waking up to the importance of having direct indexing as a piece of their offer. They are investing in adding the product today to ensure they will remain competitive and continue to win clients in the future.
Adding to the woodpile
I founded Quorus to add to the investing woodpile.
The best advisory firms need products that offer investment flexibility, empower advisors with real-time portfolio analytics, run seamlessly without adding to operational overhead, and, most importantly, deliver the best possible outcomes for their clients.
This is the product we are building at Quorus. Our direct indexing solution provides financial advisors with a sophisticated and flexible, personalized investing product designed to meet the specific needs of advisors and their clients.
We aim to be more than just a product; our team works closely with clients, sharing our expertise in direct indexing and tax-aware portfolio management to help advisors achieve the best results for their clients.
If you want to learn more about direct indexing or how Quorus can support your business, reach out to me at john@quorus.io.
Disclosures
Investing in securities involves risks, including the risk of loss, including principal. Quorus Inc., is an RIA registered in the States of Connecticut and Pennsylvania. Neither regulator has approved this message.
Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Quorus has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation.
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