Displaying items by tag: direct indexing

Until very recently, direct indexing was simply not an option for the vast majority of investors.  This is because the strategy is quite tedious to execute and could become cost prohibitive in the previous era when commission-free trading and fractional shares were not available.

This is because the strategy requires creating an actual index within an investors’ portfolio. It’s now feasible and quite easy to do due to technological advances. Additionally, the real alpha in the strategy is created through routine tax loss harvesting. 

This is an automated process where the portfolio is regularly scanned to sell off losing positions. Then, these losses can be used to offset capital gains elsewhere in the portfolio. Proceeds from the sold positions are then reinvested into stocks with similar factor scores to the ones that are sold in order to ensure integrity with the underlying index even if the holdings temporarily deviate. 

Clearly, this strategy wouldn’t be tenable without cheap and/or free trading and fractional shares for smaller sums. In the previous era, the high volume of trades would offset any additional returns. Without fractional trading, smaller sums also would not be able to track the underlying index and not be able to invest in higher-priced stocks that comprise large portions of indices. 

Finsum: Direct indexing’s proliferation is only possible due to 2 specific fintech breakthroughs - commission-free trading and fractional shares. 

As the summer ends and fall rolls around, it’s natural to expect a surge in market volatility. This is even more relevant this year given that stocks have enjoyed a period of low volatility and gently rising prices throughout most of the summer despite a variety of challenges such as rising rates, stubborn inflation, and pockets of weakness in the economy.

Further, history shows that periods of sharp increase in rates can often trigger stress in parts of the financial system that can have knock-on effects in the real economy. The most recent example is the crisis in regional banks due to an inverted yield curve which could have negative effects on the flow of credit in the economy.

For ETFTrends, Ben Hernandez discusses how direct indexing benefits from these surges in volatility. Direct indexing differs from traditional investing in funds as it allows investors to re-create an index in their portfolio. 

This allows tax losses to be harvested as losing positions can be sold with the proceeds re-invested into stocks with similar factor scores. Then, these losses can be used to offset gains in other parts of the portfolio, leading to a lower tax bill. 

Finsum: Direct indexing has many benefits but the most impactful in terms of alpha is its ability to generate tax savings for clients during volatile markets. 

Get in line?

By adding direct indexing capabilities to its arsenal, LPL Financial Holdings recently joined the crowd of wealth management firms to take the plunge, according to zacks.com.

Direct indexing, of course, is a strategy that enhances tax efficiency and tailors outcomes for clients. It’s a formidable one two combo given its high degree of promise for advisors and investors.

"Financial advisors are always looking to help improve client outcomes and deliver personalized investment solutions," said Rob Pettman, the executive vice president of Wealth Management Solutions at LPL Financial. Investors today seek strategies that enable customization, helping them achieve diverse goals such as tax reduction and sector-specific preferences, he continued.

Mention direct indexing to advisors and, well, a few ears might perk up given the interest its stimulated among them, according to thoughtfulfinance.com. 

Direct indexing, of course, is hardly a one trick pony. The ability to simultaneously address multiple ESG area, not to mention flexibility and a choice on shareholder voting just begin to describe the benefits offered to investors by direct indexing.

Direct indexing has gone from an obscure strategy only utilized by a handful of ultra wealthy investors to one that is accessible to all types of investors. In fact, many see it as the next evolution in passive investing as it captures the major benefits such as low costs and diversification. But, it also has some additional benefits such as tax savings and greater customization. According to a recent Morningstar report, tax management is cited as the number one reason that investors are increasingly choosing direct indexing. .

Currently, there is $260 billion in assets under management that is managed via direct indexing. The most common application is to simply mimic a popular benchmark like the S&P 500 or the Russell 2000. Others will endeavor to create their own index around certain themes such as ESG or companies creating jobs in the US.

Beyond surveys, the arms race in direct indexing also indicates its growing importance. Vanguard made the first acquisition in its history when it bought Just Invest and renamed it Vanguard Personalized Indexing Management. The firm sees it as one of its key growth drivers in the coming decade. Similarly, Blackstone bought Aperio, while Morgan Stanley acquired Parametric Portfolio Associates as part of its Eaton Vance purchase.

Finsum: Direct indexing has many benefits, but tax savings is the most common one cited by advisors and clients in a recent survey.

For ThinkAdvisor, John Manganaro discusses how advisors are increasingly seeing that direct index offerings are essential for high net worth clients given the enhanced after-tax returns. However, it has typically been only used with equities but there are also similar opportunities with fixed income. 

By now, most are familiar with direct indexing for equity portfolios. Essentially, it offers the benefits of index investing such as diversification and low costs while allowing for more customization and potential tax savings. 

On the fixed income side, direct indexing can allow investors to customize bond portfolios along their desired parameters such as income, duration, geography, or tax profile. There is also the potential for tax-loss harvesting during periods of volatility or bear markets to offset capital gains in other areas. 

It’s estimated that direct indexing assets will grow from $260 billion at the end of last year to $825 billion by 2026. Typically, direct indexing adds 30 to 50 basis points of excess returns although the amount can be greater in years with more volatility. For advisors, it’s a way to offer a value-added, low-cost service with greater personalization.

Finsum: Direct indexing assets are forecast to nearly triple over the next couple of years. Most are familiar with its use for equities but it is also being increasingly applied with fixed income.