Direct indexing is expected to grow faster than ETFs, mutual funds, and separate accounts over the next five years and is poised to reach more than $800 billion in assets by 2026.1
Yet, Cerulli surveys show that only 14% of financial advisors are aware of, and recommend, direct indexing solutions to clients. This is true despite 63% of financial advisors serving clients with a core market of more than $500,000 in investable assets, and 14% targeting a core market of more than $5 million.2 These numbers suggest that a lot of advisors with clients who are well suited for direct indexing are not using these strategies in their practice.
I want to take a moment to clarify the definition of direct indexing, which clients may be a good fit, and what it takes to do it well.
First came index funds
I’ve found that direct indexing is so much easier to understand when you sit it next to its older cousin, the index fund.
An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is designed to provide broad market exposure, low operating expenses, and low portfolio turnover. These funds follow their benchmark index regardless of the state of the markets.
“The trick is not to pick the right company, the trick is to essentially buy all the big companies through the S&P 500 and to do it consistently and to do it in a very, very low-cost way.”Warren Buffet3
Initially invented in the mid-1970s, index funds have been gaining in popularity over time. This could be because over the past 10 years, less than 7% of U.S. active equity funds have beaten the market, according to the Spiva U.S. scorecard.4 When you also consider that index funds have lower fees than actively managed funds, seeking to match the risk and return of the market can look more attractive than choosing an equity fund.
Then came direct indexing
It is important to note that with an index fund, the investor doesn’t own the individual stocks directly, they own units of the index fund. However, there are situations where an investor can greatly benefit from directly owning the stocks in any given index fund.
For example, with an index fund an individual investor does not have the ability to buy and sell the underlying securities, or trim any of the positions in the index fund for any reason. What if you are an employee at one of the companies and already hold a significant amount of its stock? What if a company’s data privacy and security issues were cause for concern and you want to remove it from your portfolio? An index fund investor must hold the stock as long as it’s in the index.
By directly owning the stocks in an index, the investor gains back that control. This is where direct indexing enters the conversation. With direct indexing, investors can essentially create their own index fund, but by investing in the stocks directly.
Advisors can help their clients to “match the market” but they don’t have to “be the market”—each direct index portfolio can be customized to the client’s needs and preferences. This might mean investing only in companies that align with the client's values or fit their investment preferences. It might also mean adjusting the direct index portfolio to address the client’s specific tax goals each year.
In the past, direct indexing was only possible for investors who could afford to pay for the individual trades. Lower trading costs and the expanded availability of fractional share trading lowers the barriers to entry and make direct indexing viable for a wider range of clients. And thanks to today’s technology platforms, advisors can access the sophisticated tools that they need to deliver direct indexing to their clients at scale.
How direct indexing can help clients meet their goals
As an advisor, you can help your clients evaluate if direct indexing might be a good fit for their overall financial goals.
Overall, direct indexing:
- Opens the door to more tax-efficient investing
- Allows for significantly more personalization compared to other passive investment vehicles, enabling a portfolio that reflects the client’s goals and values
- Is more cost effective than many actively-managed funds, assuming the client meets the minimum investment requirements
Some industry experts argue that tax management is the number one reason why clients explore direct indexing.5 We’d agree that tax efficiency is a big draw, but we also feel that personalization is an important component—particularly for high-net-worth clients with complex financial needs.
How advisors can prepare to offer direct indexing
For practices that haven’t offered direct indexing to their clients before, the first step is to explore the solutions available to you.
If you are already an Envestnet user, visit envestnet.com/qrg/strategies or simply search "Quantitative Portfolio" in your Research tab to see the available direct index investing options.
If you are not an Envestnet user and you’d like to learn more, visit https://www.envestnet.com/direct-indexing for downloadable resources or reach out to your home office to learn more about the options available to you.
Odds are, if your clients aren’t already asking for direct indexing, they may be in next few years, particularly high-net-worth clients. Be prepared—explore your options today.
The information, analysis and opinions expressed herein are for informational purposes only and do not necessarily reflect the views of Envestnet. These views reflect the judgment of the author as of the date of writing and are subject to change at any time without notice. Nothing contained in this piece is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.
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