Direct indexing continues to gain steam as an important offering to high-net-worth clients even if individual advisory practices have been slow to jump on board—the early adopters have been rewarded and at least one low-cost giant is already setting its sights on being a disrupter on fees.
But the window for using this level of personalization as a meaningful differentiator among advisors won’t be open forever, according to Cerulli Associates, the Boston-based research firm that included direct indexing data in its fourth-quarter publication for U.S. advisors.
In a few years, the researcher said, direct indexing will simply be table stakes.
While just 14% of financial advisors currently are using direct indexing for their clients, 50% of asset managers say they want to add or enhance this capability this year, Cerulli said. Meanwhile, 75% of broker-dealers see value in direct indexing and are prioritizing adding or enhancing this feature.
Getting into the game while it still means something, Charles Schwab & Co. said at this month’s Impact 2022 that the level of personalization offered by direct indexing—for tax loss harvesting and aligning investments with values—will reshape the industry, thanks to efficiency available through technology.
The question is how to do that at a lower cost than competitors, said Walter Bettinger, CEO, as he announced finding that path is now a priority for Schwab. Considering direct indexing is expected to be a $1.5 trillion strategy by 2025, according to a 2021 report by Morgan Stanley and consulting firm Oliver Wyman, even small fees will add up to something substantial.
“We have to get that cost down closer to where a regular ETF or an indexed mutual fund might be,” Bettinger said to some 5,000 attendees. “I can assure you that some of the digital investments that we’re making as measured in hundreds of millions of dollars, when some of those come to fruition over the coming months, you’re going to see us drive that cost for personalized indexing, direct indexing customization down to that kind of level. We’re going to disrupt that industry, and it’s going to help you serve more clients.”
According to Cerulli, asset managers with direct indexing capabilities have said that on an annual basis they can comfortably harvest tens of thousands of dollars in losses per million dollars in the portfolio, leading the researcher to say it believes that “taxes will remain the best and most widely used application of direct indexing strategies going forward.”
One asset manager that took this to heart is Valley Forge, Pa.-based Vanguard. In the fall of 2021, Vanguard Financial bought Just Invest, a fintech company with about $1 billion in assets under management.
This was the first corporate acquisition in Vanguard’s history, and it followed on a jointly run pilot program between the two companies in 2020 that tested the waters by offering the service to selected registered investment advisor clients of Vanguard Financial Advisor Services.
Following the October 2021 acquisition, the company’s name was changed to Vanguard Personalized Indexing Management, and by the time it filed its Form ADV in April 2022, its assets under management had doubled to $2 billion, primarily from the clients of some 40 advisors, the ADV stated.
While direct indexing, also called personalized indexing (PI), sounds new and exciting, it really is just the next step in a long history of customization for clients, said Colleen Jaconetti, a certified financial planner and accountant who is a senior manager in Vanguard’s Investment Advisory Research Center.
“We had separately managed accounts for a very long time, and people have done personalized indexing since the ‘90s,” she said. “What’s different now is the commissions are low to zero, you have the ability to own fractional shares, and advancements in technology have provided scale. Advisors maybe did this for 12 clients in the past. Now they can do this for hundreds of clients. It’s much more manageable.”
Jaconetti was the author of a recent whitepaper, “Benefits of Personalized Indexing: Improve after-tax investment outcomes for your clients,” that delved into the tax-loss harvesting (TLH) benefit specifically.
“Most high-net-worth investors, and the advisors who manage their portfolios, are extremely tax-averse; therefore, getting to zero realized capital gains is a critical investment objective to maximize after-tax returns,” she wrote, adding that advisors will use both investment products and financial planning techniques (like evaluating all investments held in taxable accounts on an after-tax basis, sticking to tax-efficient investments, using tax-efficient rebalancing and tax-efficient drawdown, and avoiding expensive tactical asset allocation) to get to zero realized capital gains.
However, those highly tax-efficient portfolios also may end up being portfolios that are less than optimal compared with portfolios that could be constructed if tax-efficiency weren’t the main criteria for investment selection.
For example, many wealthy clients have most of their assets in taxable accounts in light of the IRS limits on contributions to tax-advantaged accounts, like 401(k)s, so advisors tasked with maximizing after-tax returns often end up using the limited space in those tax-advantaged accounts for actively managed equities and other tax-inefficient investments like taxable bonds, which might have higher returns than the tax-efficient investments that make up the majority of the client’s portfolio.
For some of these high-net-worth investors, where the higher cost of direct indexing can be justified by the bottom-line benefit, using direct indexing within taxable accounts can result in higher after-tax returns.
Who Benefits
The clients who benefit most from direct indexing are those in higher tax brackets and who currently have significant and recurring capital gains that are expected to continue, estate plans with charitable intent or an expected step-up in basis, a portfolio holding highly appreciated and concentrated sector or style exposure, and new contributions that will be added to the direct indexing account throughout the investment period.
“One problem that can arise with systematically harvesting tax losses is that eventually the magnitude of stocks at a loss in the portfolio will diminish with time,” Jaconetti wrote. “Because of the potential capital gains that would result from selling those low-cost-basis stocks, switching to another investing strategy could be costly. For this reason, PI with TLH is more effective when there are meaningful new contributions to the investment portfolio throughout the investment period.”
Without those new cash infusions, the investment account will suffer from cost-basis “ossification,” which occurs when the daily tax loss harvesting (DTLH) reduces the number of securities with losses over time, making it harder to use this benefit, she said. Similarly, portfolio concentration might increase, as those insufficient tax-loss harvesting opportunities reduce the ability to diversify. And finally, portfolio staleness might occur, which is what happens when a portfolio resembles the winning stocks at the time the portfolio became active, not the stocks of the present.
It’s not for everyone—some clients can have portfolios that realize little or no recurring capital gains on their taxable accounts, and some of the downsides of direct indexing (ossification, concentration and higher costs) may make mutual funds and ETFs better investment vehicles.
“DTHL is very beneficial with people who have material recurring capital gains. They’re holding something tax-inefficient through, say equity investments. If they have $10,000 gains and you can offset that with losses, you go from taxes to no taxes,” Jaconetti said. “Who else might have recurring gains, other than tax inefficient in taxable accounts? People with highly concentrated positions. They might think over time they’d like to diversify but they don’t want to pay the tax bill. As you’re selling out you can use it to offset gains.”
In general, she said, retirees should sell their tax-advantaged accounts first, but if they have a very large taxable portfolio, they might want to consider pairing it with direct indexing to make the most of distributions from the taxable side of their investments.
Direct indexing also benefits clients who will have a future capital gain event, such as selling a business. “You can carry forward any losses, and each year you can offset $3,000 in ordinary income,” she said.
In addition, advisory practices that work to generate higher returns through actively managed equity mutual funds and ETFs, private equity, hedge funds and other alternative investments can benefit from direct indexing on behalf of their clients. Pairing these lucrative but tax-inefficient investments in taxable accounts with direct ownership of securities and access to daily tax-loss harvesting is likely to result in higher after-tax outcomes than if none of the strategies were employed, the paper said.
Advisors who should consider direct investing for their practice including those dedicated to access management and those who use private equity and hedge-funds.
Evaluating Cost
According to Vanguard, the average cost of direct indexing is now roughly 25 basis points, while the cost of investing in a mutual fund or ETF is more like 5 basis points. But deciding how much to invest in direct indexing is not an all-or-nothing strategy, as for many portfolios an advisor could invest only as much as is needed to off-set gains and investing the rest in cheaper options.
When analyzing the trade-offs of using direct indexing over a mutual fund or ETF, in general, the larger the expected alpha and the amount of gains to be offset, the greater the portion of an equity portfolio that could benefit from direct indexing.
For example, in a Vanguard-provided, hypothetical scenario where a client has a $1 million portfolio, a capital gains rate of 20%, a 20 basis point difference between direct indexing and lower cost mutual funds/ETFs, zero expected alpha and $5,000 of capital gains to be offset, the expected benefit from implementing direct indexing would be $1,000 (expected alpha plus tax savings).
That means that with a $1,000 benefit, an advisor could allocate up to 50% of the equity portfolio to a direct investing program, as the expected alpha plus tax savings is equal to the estimated cost at 50% of the portfolio. Allocating more than that would exceed the expected alpha plus tax savings, and therefore a mutual fund or ETF would be superior for that part of the portfolio. Allocating less than that would be wasted opportunity.
“It’s a great new development, but not for everyone,” Jaconetti surmised. “It really depends on if portfolios are set up efficiently. If people have gains, or want to hold actively managed funds, that’s when they might want to look at it.”