If you are in the wealth management and investing space, you have likely heard of direct indexing. Next to personalization, holistic advice and tax optimization, direct indexing is one of the hottest topics in this industry. Despite the hype, it’s more than a passing trend. Cerulli predicts direct indexing assets will top $800 billion in the next three years, outpacing the growth of mutual funds, Separately Managed Accounts (SMAs) and ETFs by 2026 (Source: Cerulli Associates, The Case for Direct Indexing: Differentiation in a Competitive Marketplace, December 2022). And according to Goldman Sachs, financial advisors see direct indexing strategies as an effective way to deliver on goals.
Direct indexing, which aims to replicate equity index performance using SMAs, has been around for more than two decades. It initially served as a passive investing alternative but has evolved to something with more staying power.
Indexing has increasingly attracted attention due to its potential tax advantages, especially for investors with substantial unrealized gains, thanks to strong equity market performance since 2009. When it comes to personalized investing strategies, however, the question remains, has wealth management succeeded in bringing them to customers at scale? If not, how can we break through the ceiling?
Personalization At Scale
Personalization at scale is the ability to provide customized and tailored services to a large number of clients, especially in the field of investing. It involves several aspects, such as tax optimization, values alignment, and concentrated holdings or risk management.
Scale is the biggest challenge advisors face, however. Firms need to scale individualized investing, including direct indexing, if they want more clients to benefit, as manually implementing customization and tax management is a tedious and time-intensive task for the advisor. Personalizing accounts one at a time may be feasible for ultra-high-net worth relationships, but it’s simply not viable for most clients, even as demand rises for democratized access to tailored services.
Tailoring services to meet the specific needs of each client involves several moving parts. Personalizing tax management is one aspect, but aligning investments with client values including environmental, social and governance (ESG) factors, or addressing unique financial situations, such as concentrated holdings/risk scenarios arising from having company stock or owning a family business, are also critical components.
Tax Optimization
For many years, direct indexing strategies have provided personalized tax management and optimization capabilities. With the advent of some advanced technology, these solutions are rapidly becoming more sophisticated and providing opportunities to enhance personalization at scale. Each investor’s unique federal and state tax rates and budget for taxes on net realized portfolio gains can be considered in the management and rebalancing of the portfolio, creating an individualized experience. Additionally, taxable gains and losses can be taken into account—and thoughtfully managed—when transitioning assets to new strategies, offering yet another kind of personalized service.
Again, to reap the benefits of these capabilities, scalability is key. Direct indexing platforms that deliver on their promise of personalized tax optimization offer a solution that can store individual tax rates, tax budgets, and perform ongoing tax optimization at the individual level. Tax-loss harvesting is a direct-indexing feature that can reduce taxes on investment gains by selling securities that have lost value and offsetting them against the gains.
There’s an enormous benefit here, since taxes can take up to 40% of someone’s returns in a year, according to Wells Fargo Private Wealth Management chief investment officer Adam Taback. Looking to 2024, investors also need to brace themselves: President Biden’s 2024 budget proposal includes a significant increase in the capital gains tax rate for high-income individuals. Individuals with incomes over $1 million would face a marginal capital gains tax rate of 39.6%, effectively doubling the current rate.
Providing personalized services to clients with varying tax profiles at scale is a quantum leap forward for our industry. It’s also part of a larger principle of prioritizing efficiency and scale. The majority of providers operate on a simplifying assumption that every taxpayer pays a top federal income tax rate, and pays no state income tax, two assumptions with potentially significant consequences for investors.
Of course, there’s no guarantee that investment strategies that seek to replicate index returns or enhance after-tax performance will achieve any particular result. Investors should check with their accountant or other U.S. tax advisor before investing.
Enabling Seamless Connectivity
Simplified portfolio management is key to a successful advisory practice. We’ve learned that when direct indexing solutions have been built manually in-house, simplicity and ease of use may take a backseat to other concerns. To help advisors succeed and stay relevant to clients, we believe the focus should be on developing an intuitive interface that makes direct indexing solutions easy to use, even for complex strategies. For scalability to be realized, this needs to be powered by automated workflows, allowing a broader range of users, including novice advisors, to adopt the product to their practice.
The few independent tech providers with deep knowledge of wealth management remaining in the market can make a difference here, since we are not constrained by legacy systems. Technology is the key to solving the challenge of personalization at scale, and seeing what untethered innovation can produce is what’s most exciting about the future of direct indexing, as it evolves beyond a passive approach to address unique circumstances for individual investors.
Robert Battista, CFA, is senior vice president of Advisory Solutions at Vestmark, a leading provider of portfolio management solutions and outsourced services for financial institutions and advisors. Battista has a Master of Finance degree from Penn State University and a bachelor’s degree in business administration from Elon University.