Displaying items by tag: direct indexing

A recent article from Morningstar’s John Rekenthaler discussed the tax benefits of direct indexing. Direct indexing is a strategy that involves directly buying the stocks of an index rather than through a fund. 

This confers several benefits such as allowing investors to gain the benefits of indexing while still being able to customize their portfolio to reflect their values and better fit their needs. Due to this, the category has exploded and gone from a niche offering solely for high net-worth investors to being offered by retail brokerages to customers for as little as $5,000.

However, the strategy is not necessarily for everyone, but it can be particularly useful for those with sizeable assets due to the potential tax benefits. This is because direct indexing results in capital losses in a separate account when stocks drop below their cost bases. The proceeds are then re-invested in stocks with similar profiles. 

This strategy can be particularly useful for investors with high federal and state taxes, large amounts of money invested in direct indexing vs other investments, short-term capital gains, and dealing with a volatile market environment. 

FinSum: Direct indexing comes with several benefits for clients but the most substantial one is the tax savings. However, it’s only worthwhile for a particular group of investors.

There is no question that investing in low-cost mutual funds or exchange-traded funds that mirror a benchmark index is a popular strategy to potentially reduce the impact of fees on a portfolio. In fact, many of these passive index strategies have often outperformed more costly actively managed funds. However, while tax efficient, they are unable to fully take advantage of short-term market volatility, according to Neale Ellis and Matthew Michaels of Fidelis Capital. On the other hand, direct indexing has become an attractive alternative to a portfolio of low-cost funds and ETFs, and unlike owning a mutual fund or ETF, an investor directly owns a basket of individual stocks that tracks a designated benchmark index. The strategy also allows greater flexibility during periods of volatility to selectively harvest losses while still closely tracking the benchmark. This is due to the fact that individual equities tend to see much higher volatility than a diversified mutual fund or ETF. This increases the opportunity for tax loss harvesting. Realizing losses in a portfolio can offset capital gains, which creates tax savings. Failing to harvest those losses during periods of short-term volatility could lead to lower results, essentially leaving money on the table.

Finsum:While passive index ETFs are tax efficient, they are unable to fully take advantage of short-term market volatility, which is something that direct indexing can do.

According to a recent study, advisors are moving away from revenue-sharing products such as mutual funds and toward products such as ETFs and SMAs due to regulatory pressure and changing investor preferences. In fact, advisor use of mutual funds is expected to decrease by 13% by 2024, according to research by Cerulli Associates. Dennis Gallant, associate director at Boston-based analytics firm ISS told FA-IQ that affluent clients tend to expect products that can be personalized, such as separately managed accounts, and capabilities such as direct indexing could bring that personalization down market” Iraklis Kourtidis, co-founder and chief executive officer at Rowboat Advisors, a direct indexing provider told the magazine that there are three main reasons why custom portfolios are preferential for advisors. He said one is to meet clients’ environmental, social, and governance preferences, “which you can’t do within a fund because it’s one-size-fits-all.” The second reason is tax efficiency, particularly tax-loss harvesting, “which you also can’t do with a big fund where you lump all the money together.” According to Kourtidis, the third “much less talked about” reason is the concept of “completion portfolios.” He said, “If someone has a lot of tech exposure through stock with their employer, for example, you can give people a custom portfolio that offsets that.”

Finsum:According to research by Cerulli Associates, advisors will be moving away from mutual funds and towards ETFs and SMAs due to regulatory pressure and changing investor preferences such as personalization.

While direct indexing might be ready for added use this year, according to one expert, it’s hasn’t quite hit prime time when it comes to the majority of the wealth management industry, reported fa.mag.com.

“I’m not necessarily of the view that 2023 will be the year that direct indexing becomes broadly democratized,” said Anton Honikman, CEO of MyVest. “There’s a different discussion about bringing direct indexing to a broader market. What’s hindering that is the need for more of an experience with direct indexing.”

He continued: “I’m a fan of direct indexing,” said Honikman. “I think it will continue to grow, and I think it’s emblematic of an inexorable trend towards more personalized solutions.” That said, he also noted it’s “emblematic of the real interest and desire for more tax management -- particularly among the affluent and high-net-worth investors. For those reasons, I’m really positive about its future.”

But this year, however, when it comes to wealth management, direct indexing won’t be omnipresent.  Thing is, the technology that will abet the ability of direct indexing to maximize its potential isn’t in place, he noted. The personalization of financial plans and portfolios at scale would be enabled with such technology.

Rather, this year’s game plan will see technologists and wealth management firms remain on the road toward investing in overcoming issues evolving around personalization, added Honikman.

Based on a report by Cerulli Associates, over the next five years, direct indexing’s assets are expected to spike by more than 12% annually, according to investmentnews.com.

Jonathan Foster, president, and CEO of Angeles Wealth Management, recently penned an article on MarketWatch where he listed the benefits of direct indexing for retail investors. Foster noted that while direct indexing is primarily used by high-net-worth investors that are seeking to optimize their after-tax returns, the widespread elimination of brokerage trading fees and the growing availability of fractional share trading have led to greater adoption of direct indexing. According to Foster, the advantages that direct indexing can bring to a portfolio include ‘dirty money,’ outmoded mutual funds, and personalization. Foster says that ‘dirty money’ refers to investors expressing concern about how the companies they invest in make money. For instance, direct indexing offers advisors the ability to craft portfolios that exclude what their clients believe to be “dirty money.” Foster uses tobacco as an example. In this instance, direct indexing can help an investor craft a tobacco-free portfolio. Outmoded mutual funds refer to investors using mutual funds in taxable accounts and not having the benefit of starting with their own individualized cost basis, which can lead to distributable annual taxable gains. With direct indexing, investors can take advantage of tax-loss harvesting. Direct indexing can also offer investors an opportunity to customize portfolios with strategies such as ESG.

Finsum:A wealth management executive recently wrote an article on MarketWatch advocating for direct indexing due to benefits such as excluding certain securities, employing tax-loss harvesting, and customizing a portfolio for certain strategies.