Understanding Direct Indexing: A Personalized Investment Approach

Executive summary:

Direct indexing seems to be all the rage these days, and for good reason. It gives investors flexibility and allows them to create a personalized portfolio
Direct indexing has become increasingly popular in recent years as a number of new products has made this strategy available to a wider swath of investors
One of the main advantages of a direct indexing strategy is that the investor owns their capital gains and losses, allowing them to use the latter to offset the former and reduce their tax liability
Direct indexing can help advisors solve a variety of investor problems

You’ve probably heard the term “direct indexing.” It seems like everyone is talking about it. You’ve probably also read that sales of direct indexing products are booming. But what exactly is direct indexing?

Well, in its simplest form, it’s a strategy in which an investor purchases a selection of the securities that make up a specific index. This is vastly different from an Exchange-Traded Fund (ETF) that tracks an index or a mutual fund that follows a benchmark index such as the S&P 500. Mutual funds and ETFs are comingled funds: everyone who buys that mutual fund or ETF gets the same combination of securities.

Direct indexing, on the other hand, allows investors to directly own a group of securities that represent an index (or a large enough portion of them, but more on that later) and hold them in a Separately Managed Account (SMA). This gives the investor the same market exposure as the index but also gives them the opportunity to build a customized portfolio. The investor can exclude certain securities or increase their exposure to others to reflect their specific goals, needs, or circumstances. This approach not only allows for greater customization but also greater flexibility.

This type of investment has long been available to high net-worth and institutional investors. But in recent years, a wave of acquisitions and the launch of proprietary solutions from a variety of asset managers has made this product more widely available to retail clients.

Since most retail investors don’t usually have the funds to buy all the securities in an index, providers of direct indexing products use “sampling.” That’s pretty much what it sounds like. The portfolio manager will take “samples” of the securities that make up an index to ensure the overall exposures of the resulting portfolio still reflects those of the entire index. This has made direct indexing more accessible to a broader range of investors.

How popular is direct indexing?

Assets in direct indexing products reached $535.1 billion in assets under management at the end of Q3 2023¹. A report by Cerulli Associates projects that direct indexing will make up 33% of the retail SMA market by 2026 and assets held in direct indexing products will reach $800 billion².

One of the drivers of the increasing popularity of direct indexing is that it can help advisors meet the growing demand for customization from their clients. Think about your clients: some are more tax-sensitive than others, some have strong values they’d like reflected in their portfolio and others don’t, some want to avoid investing in certain companies or industries for specific reasons. Some want to gain extra exposure to certain industries to express their belief in a theme or trend. With direct indexing, meeting those client needs is possible.

We believe direct indexing is a game-changer. With direct indexing, you have the flexibility to construct a personalized portfolio tailored to your clients' specific preferences and goals. The chart below shows that direct indexing is emerging as the leading choice among SMA options.

Source: FUSE, Money Management Institute, Cerulli Associates. Used with permission.

Why use direct indexing?

There are a lot of benefits to owning the actual securities directly instead of a packaged vehicle like a mutual fund or ETF. When you buy a packaged or comingled vehicle, not only are you getting the exposure determined by the fund manager, you are also affected by the actions they may take. For example, if the fund sells securities throughout the year, the fund company is required by law to distribute the gains to all shareholders in that year. These capital gains distributions have been a thorn in investors’ sides for years, as investors are taxed on them. To make matters worse, fund managers are not allowed to distribute any net losses, eliminating a potential opportunity to offset the gains.

What are the tax advantages of direct indexing?

In comes direct indexing. When an investor sells an individual security, this either generates a capital gain or a capital loss. When shares are sold at a gain, the investor must realize those gains that year. This is an issue with active SMAs, because any turnover or selling done by the manager results in a capital gain for the investor. The more turnover there is, the more likely there is to be capital gains generated that the investor must pay taxes on in that year. But with direct indexing, any capital losses can be used to offset capital gains at the household level. In other words, gains in the portfolio can be offset by the losses, but so can gains in other portions of an individual’s overall portfolio (such as from the sale of a property or business). This can greatly help to reduce the investor’s tax liability.

Since the objective of direct indexing is to track a particular index, and indexes have no turnover outside of reconstitution, the manager of a direct indexing portfolio does not have to sell anything. Instead, the manager can strategically sell losing positions, replace those positions with other securities to maintain close tracking with the index and realize a LOSS. This means that when the investor does their taxes, they will have these net losses that can either be used to offset any capital gains they may have or carried forward to be used in future years (up to $3,000 in net losses not used to offset gains can be used in the current tax year while any excess amount can be carried forward).

Is direct indexing suitable for all investors?

This depends on the investor’s goals, needs, and circumstances. Through our work with advisors, we’ve pinpointed key areas where direct indexing may markedly benefit investors:

Effectively managing concentrated stock positions
Strategically preparing for taxable events
Smoothly transitioning unmanaged accounts
Personalizing investments to individual preferences
Implementing year-round tax loss harvesting
Charitable giving

Advisors should also be aware that investors who closely follow benchmark performance may not find direct indexing to their liking. Because of the ability to customize exposures, using direct indexing in a SMA will result in performance that deviates from the index. Be sure your investors are able to tolerate some tracking error when recommending a direct indexing strategy.

The bottom line

Given our passion and heritage for tax management at Russell Investments, we tend to focus on taxes but there are a lot of other potential benefits to direct indexing such as the ability to express strongly held values, reducing the concentration risk of a portfolio, and undertaking efficient charitable giving. Direct indexing can also be combined with active management to create a single custom SMA. An advisor who offers access to both direct indexing and active strategies can meet a variety of client needs.

¹ Source: FUSE, Money Management Institute, Cerulli Associates.

²Source: https://www.cerulli.com/press-releases/cerulli-associates-projects-direct-indexing-assets-to-top-800-billion-by-2026-while-outpacing-growth-of-etfs-mutual-funds-and-smas

Disclosures

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