Direct indexing, despite its tax advantages and customization ability, remains a mystery to more than half of advisors, according to Jennifer Sireklove, managing director of investment strategy at Parametric Portfolio Associates, a Seattle-based firm that is part of Morgan Stanley Investment Management.
“I can understand the lack of knowledge about direct indexing for many advisors because they already are using successful strategies for portfolio construction and they don’t want to mess with success,” Sireklove said in an interview. “Many do not fully appreciate the tax benefits that can be achieved using direct indexing or the fact that portfolios can be customized to fulfill a client’s specific goals or ESG beliefs.”
Besides the potential for smaller tax bills overall, individual security ownership can improve tax efficiency for investors transitioning between managers, making charitable contributions, and managing or unwinding concentrated positions, Parametric said.
Sireklove said she frequently gets questions on direct indexing from advisors who want to tailor portfolios to clients’ specific desires.
Direct indexing is an index investing strategy that involves directly purchasing the components of an index at the same weights as the index. Direct indexing can provide greater autonomy, control and tax advantages to investors compared to owning an index mutual fund or an index exchange traded fund, according to Investopedia.
Direct indexing is no longer the provenance of ultra-high-net-worth individuals, although it is most frequently used by those who are of least high net worth. Investors in international and domestic stocks would need at least $250,000 in investable assets, she said.
Some firms have dropped minimums even lower as direct indexing becomes better known and more popular.
The ability to own individual stocks through direct indexing enables investors to take advantage of tax loss harvesting, Sireklove pointed out. “Investors can also sidestep a lot of the opaqueness of ESG funds and invest directly in companies they want to support by using direct indexing,” she added.
According to a survey conducted by Cerulli for Parametric, “even though direct indexing is primed to grow at an annualized rate of more than 12% over each of the next five years, the majority of advisors surveyed were unfamiliar with the strategy despite embracing” the tax management and customization that it enables. “This comes at a time when the strategy is experiencing rapid growth, totaling more than $362 billion in assets in 2020, which is nearly one-fifth of the financial industry’s total in retail separately managed account assets.” The survey included 200 advisors across the independent and hybrid RIAs channel, wirehouses, national and regional broker-dealers, and independent broker-dealers.
“Despite all the growth and attention direct indexing has received, our survey shows there is still room for substantial growth in advisor awareness and of the product and the values it provides,” Brian Langstraat, CEO of Parametric, said in a statement. “This suggests that the next part of the growth curve could be even steeper than some have projected.”
The survey, Advisor Perspective on Direct Indexing, found that among advisors who avoid direct indexing entirely, the majority claim they are satisfied with the solutions they currently recommend to clients, preferring to project the confidence that comes with product familiarity and remaining in their comfort zone. The survey also found that direct indexing allocations rise with the AUM of the advisor.
“The time is now for advisors to learn about direct indexing and adopt it for their practice,” Parametric said.