March 24, 2021

​DIRECT INDEXING: Is direct indexing right for me?

Key Takeaways:

• Direct indexing adds value when working with a taxable client/portfolio
• If you need to transition a portfolio of legacy/inherited securities, direct indexing can help
• A single-stock concentrated position can be addressed in a direct index solution
• When a client has customization needs, direct indexing can be a great solution

One of the most frequent questions we hear is “how do I know if direct indexing makes sense for my clients?”  This is a great question and should be one of the first steps in looking into separately managed accounts (SMA), direct indexing, and many of the components of direct indexing.  Below are some of the most common scenarios that we run into when working with clients:
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• Taxable Client / Portfolio - If you have a taxable client, chances are there are advantages of using a direct index solution.  Tax benefits can come in many different forms.  Just look at the utilization of mutual funds and then ETFs over the last 50 years.  It was identified that by changing the investment vehicle and structure, a taxable investor could benefit.  Mutual funds provided lower cost access to diversification and capital markets.  Moving from Mutual Funds to ETFs allowed an investor to benefit from the creation/redemption process allowing in-kind payment so investors do not incur most capital gains in the investment vehicle.  Direct indexing is the next step in this progression.  Owning the underlying securities in an SMA vehicle (which does not happen in ETF and Mutual Fund vehicles) allows the investor to benefit from the gains and losses of the individual securities themselves.  The result is a term called “tax alpha.”  In simple terms, tax alpha measures how much better off your portfolio is on an after-tax basis.  Direct indexing can either defer the realization of gains or realize losses to offset gains elsewhere in the portfolio.  Both of which can be very beneficial to a taxable investor.

• Legacy / Inherited Securities – Even if an advisor does not typically manage their client assets in SMA vehicles, chances are their clients either have or will have individual securities at some point.  Alternatively, every advisor has worked with a prospective client that is coming over from a firm/advisor that managed individual securities.  One of the biggest advantages of a direct index portfolio is that it can accommodate legacy individual stocks.  Most of these stocks have some form of embedded gains.  Consequently, as an advisor you can either sell the positions and incur a large tax bill for the client or you can retain the stocks.  Direct indexing allows you to retain the positions, defer incurring he gains, but still construct a portfolio that is transparent, tracks an index, and meets your client’s overall portfolio allocation goals.

• Concentrated Positions – Have you ever worked with a client that has one or a handful of large, concentrated positions?  Inevitably, we all run into this scenario and it is a difficult one to overcome.  The concentrated position creates several issues including reduced diversification, over-concentration in sectors/industries, and a general deviation from your desired portfolio allocation.  Stock specific risk is real, and it can impact your client’s long-term investment objectives.  Direct indexing can help in a couple of ways.  First off, direct index vehicles help an advisor construct a portfolio around the concentrated position to attempt to reduce the concentration and impacts on portfolio allocation, thus reducing idiosyncratic risk caused by the concentrated position.  Secondly, direct indexing can generate losses which can then be used to offset gains incurred when you sell out of the concentrated position.  SmartHarvest can take this concept a step further by implementing other concentrated position solutions like single stock call writing and synthetic exchange fund creation.  These are more advanced solutions that we can implement with third-party partners in the option/derivative space.

• General Customization – This category includes many different client needs.  Technically speaking, taxes, concentrated positions, and legacy securities are all client-specific issues that require a truly customized solution.  But we can take customization further in many different directions.  If a client has particular Socially Responsible (SRI/ESG) views that they would like reflected in their portfolio, direct indexing allows for a very customized solution that can address all of their needs.  We can customize stock or industry specific views or a general theme like human trafficking, animal cruelty, and much more.  Maybe your firm has a very specific view on markets that requires a particular asset allocation.  This can include a particular exposure to asset classes, factors, securities, sector/industry, etc.  All of these can be customized to meet the needs of your firm allocation or client need. 

 
Direct index investing may not be necessary in all scenarios, but it can make a lot of sense for many clients and portfolios.  The complexity of these scenarios can range from simple, a taxable client that would benefit from tax loss harvesting and superior after-tax returns, to a more complex scenario in which a client has legacy stock holdings, embedded gains, a concentrated position, a very nuanced tax situation, charitable gifting needs, and SRI/ESG views.  Most clients only have one or two of these needs, but direct indexing can resolve one or all of these scenarios for you and your clients.  Have a particular client situation?  Just let us know, we are happy to talk through it with you.