When it comes to personalized investment strategies, multiple perspectives come into play: the client, the provider and the advisor. Investors’ concerns can range from tax management to market exposure to a portfolio aligned with their personal values. And both advisors and solution providers can have vastly different levels of knowledge and experience.
Although best known for tax management, direct indexing offers a wide array of approaches to meet investors’ goals. For advisors looking to personalize a portfolio, it can be a matter of knowing where to start. Let’s take a look at some questions to consider.
How might different investors benefit from direct indexing?
Different investors have different priorities, and direct indexing may not be ideal for all investors. Is the client willing to invest in more complex products? What has their previous investment experience been like? Understanding the investor’s perspective can help advisors build the right portfolio for them.
Direct indexing allows investors to personalize their portfolios based on their priorities and may help them to:
• Identify and seek to take advantage of tax efficiencies
• Avoid overconcentration in a particular stock or sector by avoiding redundant or risk-compounding portfolio holdings
• Adjust allocations to overweight or underweight certain market sectors
• Combine multiple benchmarks to achieve their desired exposure
• Screen out certain industries or companies that don’t align with their values
Passive index-based mutual funds or ETFs may be relatively tax-efficient, but a direct indexing portfolio can offer additional tax benefits. Taking a core-satellite approach, for example—incorporating active strategies as “satellites” around a systematic, rules-based direct indexing core—allows investors to harvest tax losses in the core to offset gains that active satellites might generate. And if the active satellites underperform, tax-loss harvesting in the core can help soften the impact. Such a direct indexing strategy is not only inherently tax-efficient, it can also produce losses investors can use to offset other gains among their holdings. Commingled funds offer limited tax efficiency but aren’t able to pass on realized losses to the investor. With direct indexing, investors can employ risk-controlled tax-loss harvesting all year.
Investors might also look for different levels and combinations of personalized market exposure. Direct indexing allows investors to optimize an index to suit their needs, rather than investing in one single basket of indexed securities through a commingled fund. An active/passive portfolio that includes direct indexing could allow an investor to customize or overweight small-cap exposure, for example, or even broaden their holdings to incorporate international exposure, while also potentially improving tax efficiency. With a custom SMA, investors have more direct control over which securities get emphasized, ensuring their portfolio reflects their market views. That type of control over individual security ownership is at the heart of direct indexing, and a custom SMA allows investors the flexibility to work with their advisor to diversify their portfolio and adjust accordingly should their views change.
There’s more to responsible investing than environmental, social and governance (ESG) concerns. Investor remain interested in aligning portfolios with personal values. In addition to potentially screening out fossil fuels, for example, direct indexing also empowers investors to build portfolios that reflect their faith. A client’s definition of responsible investing is the one that matters most.
Who provides the right direct indexing solutions?
Just as investors’ priorities might vary, different solution providers offer a variety of investing tools and approaches. We hear a lot about ETFs and other commingled funds, but direct indexing offers personalization many investors seek in a more tax-efficient manner. As a result, direct investing continues to grow as more advisors and investors come to understand the benefits. When researching different providers, advisors and investors might look for differentiators like years of experience, scope of customization opportunities, innovation and so on. The opportunities for personalization led Parametric to launch our first direct indexing account back in 1992, and our research continues.
The reality is that not all providers are created equal. Choosing the right provider is critical to helping investors make the most of their portfolios. When researching direct indexing solutions, it’s important to consider the following:
- • Does the provider have the right expertise and scale?
• What types of exposures can the provider capture?
• Is the provider readily available?
• How closely does the provider focus on tax management?
How should advisors prepare to use direct indexing?
Advisors may not know how to talk to clients about the many benefits direct indexing might offer. It’s helpful to start with a look in the mirror. Evaluate your own knowledge and expertise around direct indexing and identify any gaps. What don’t you know? Then look to thought leaders in the area—say, a service provider with decades of direct indexing experience—to fill those gaps. If you feel comfortable with your understanding of the potential benefits of direct indexing, the next question is considering your client’s needs and priorities. Direct indexing can help you incorporate their values and achieve their desired market exposure.
At Parametric, we’re always exploring new ways to help advisors serve their clients and are happy to share what we’ve learned over the decades. Arming yourself with information can help you start the conversation with your clients and help them identify the right approach to meet all their goals.
Personalize tax-managed portfolios around client needs
The bottom line
Direct indexing offers investors and advisors many different ways to build and manage customized portfolios. For investors looking to meet financial goals in ways that reflect their priorities, incorporating a systematic, rules-based direct indexing strategy can help personalize portfolios and potentially maximize tax efficiency. By understanding how direct indexing might benefit their clients, advisors and solution providers can work together to give them the control they seek over their investments.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
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