Do You Offer Direct Indexing Yet? What You Should Know as an Advisor

Investopedia.com defines direct indexing as “an approach to index investing that involves buying the individual stocks that make up the index, in the same weights as the index.” For example, rather than owning a mutual fund or ETF that tracks the S&P 500, investors can replicate the index, meaning they would own all of the individual 500 stocks that comprise the index. Investors can also sample indexes, which simply means purchasing enough of the index holdings, whereby the investor should receive similar exposures, and returns, as the index. Sampling is often done when replication is not possible or too inefficient, and a great example of how many advisors are looking to direct indexing to slowly offload a large position with a low basis (more on that later).

Direct indexing is consuming a lot more ink recently, and one of the primary reasons might be that the elimination of commissions on equities has made it dramatically less expensive to pursue. And, technology, too, might be a big driver. New software tools open the door for an advisory practice of any size to offer it. Orion’s ASTRO, as an example, is an affordable direct indexing tool that advisors on our Orion Essentials platform at XYPN Invest can seamlessly build into their trading tech. In the recent past, advisors had to look to professionally outsourced options when direct indexing was needed. And a third possible explanation: custodians introducing fractional share purchases have helped to expand the opportunity for direct indexing to relatively smaller accounts where the volume of tickers required and minimum share prices would’ve previously demanded substantially higher assets to accurately sample an index.

With increased interest in direct indexing naturally came an uptick in M&A activity. Fund companies and other large investment companies have looked for a quick entry into the market by acquiring direct indexing providers, such as in these examples: 

• Vanguard → Just Invest 
• Morgan Stanley → Parametric
• BlackRock →Aperio 
• JP Morgan → OpenInvest
• Franklin Templeton → Canvas 
• Goldman Sachs → Folio 

And don’t forget that other new entries into the market include asset managers like Dimensional Fund Advisors and Avantis, and custodians (Schwab, for example) are now in it, too. 

So, what’s all the fuss about?

In short, the proliferation of direct indexing gives advisors the chance to help their clients achieve good outcomes in increasingly more unique and customized ways. I’m certainly not forgetting that mutual funds and ETFs are still perfectly viable solutions in most cases. But, direct indexing might appeal to advisors in situations when:

• Individual securities are preferred over funds. Many client portfolios in the wirehouse channel are still comprised of individual stocks. If those clients were to move to an RIA, they might not necessarily be able to make a complete and immediate transition to funds.
• A client is likely to remain in a high tax bracket for an extended period of time. Advisors can leverage this structure to create a custom capital gains experience and increase opportunities for tax loss harvesting.
• Extreme portfolio customization is required. Whether to take advantage of certain factor tilts or to implement a bespoke ESG (or values-based) solution, there are countless opportunities available for customization across the direct indexing solutions landscape.
• A low-basis position requires special handling. Direct indexing can provide advisors with the opportunity to incorporate an individual security while it awaits charitable giving opportunities or to gradually deplete it while harvesting losses elsewhere in the portfolio.

What are some of the challenges of direct indexing?

Some of the challenges of direct indexing are specific to the client while others are specific to the advisor.

Client-specific challenges include:

• For certain direct indexing solutions, minimums can be very low ($1,000) though most are much higher ($250,000).
• Due to all the trading that takes place, clients may want to turn off their trade confirmation notifications, otherwise, they will be notified each time a trade is made. Similarly, gain/loss recordkeeping for clients and tax preparers can become voluminous.
• Limited asset class availability. Direct indexing solutions may not be available for all the asset classes that clients have in their portfolio, such as international small-cap or REITs.
• In order for the tax optimization to be most effective, there needs to be consistent inflows into the portfolio, allowing for the purchase of new tax lots. Without consistent inflows, the ability to do tax loss harvesting diminishes over time as markets march higher.

There are also some advisor-specific challenges, including:

• It is much easier for advisors to rebalance a portfolio of mutual funds and ETFs. Advisors who implement direct indexing themselves will likely have a less efficient rebalancing process.
• Unlike mutual funds and ETFs that have their fees embedded into the product, fees for outsourced direct indexing will appear as a line item on statements.
• There may be software costs to account for in order to gain access to certain direct indexing solutions.
• Becoming the asset manager—for some direct indexing solutions, the asset manager is the one reviewing and directing trades, monitoring tracking errors, and doing the daily portfolio upkeep. However, in other solutions, this work is all up to the advisor. Advisors may need to increase staff and/or trading expertise in order to dramatically increase their usage of this type of direct indexing solution.
• Due diligence—when an asset manager has discretion, it is incumbent upon the advisor to periodically perform due diligence on the asset manager to make sure they are doing what is expected.
• Custodian availability—advisors will want to make sure the solution being considered is available with their current custodian or be willing/able to add another one to their practice. The list of outsourced managers is far longer when holding accounts at a traditional custodian as compared to digital investment platforms.

How to choose the right direct indexing solution for your clients?

Currently, there is no shortage of available direct indexing options to choose from, with the list likely to expand. As an advisor, there are many characteristics to understand before determining the right solution(s).

• Outsourced vs. DIY. As a financial planner, do you also want to act as the portfolio manager? 
• Costs to your firm and to your clients
• Minimum account sizes
• Tax optimization capabilities (ie, technology used, track record)
• Availability and transparency of performance reporting
• Ability to customize 
  
  • ESG and values-based screening
  • Factor tilting
• Managing for tracking error/number of securities owned
• Whether the product is custodian agnostic or custodian specific
• Product availability
  • Asset classes tracked
  • Benchmark availability

What if you have a strong preference for funds over individual securities?

Using our own trading practices at XYPN Invest as an example, we can accommodate individual securities as needed into our ETF/Mutual Fund models. For situations where low-basis positions require special handling (e.g.: for either eventual charitable giving or to slowly realize gains over multiple tax years), we’ll count them towards the equity portion of the model and reduce all of the other equity purchases. And even in the rare case of a low-basis fund, we can count that towards one specific asset class if that might be a reasonable proxy for one of our model holdings. You can create these same workarounds in your trading practices by thinking through and plotting out the equivalencies. 

Coca-Cola (ticker: KO) might not be the perfect proxy for your entire Large Cap allocation, for example, but generally counting towards equity seems quite reasonable. Your portfolio implementation—with an allocation to the legacy KO holding—might be more heavily tilted to US equity or to Large Cap than your target model, but it’s sometimes the right trade-off if the unrealized gains in your KO shares are too much of a burden to offload in one tax year. Making these decisions in coordination with your clients and their tax advisors will prove to be quite valuable in building trust and proving your value.

What is the bottom line when it comes to direct indexing?

While direct indexing has recently become a hot topic, it is not a new concept and definitely not a fad to be ignored. It’s sure to become common practice in the majority of service-focused advisory businesses like yours. And the beauty of direct indexing is that it can be highly impactful in very narrow circumstances. It does not require a mass rollout to all clients at once. Interested in learning more about direct indexing and the services XYPN Invest offers you and your clients? Reach out to XYPN Invest to learn more and ask any questions you may have about all things investing. 

About the Author

Jeff Snodgrass is the Managing Director of XYPN Invest, which provides turn-key investment management solutions for time-savvy advisors ready to streamline their investment process. Jeff's favorite part about his job is connecting with the advisors XYPN Invest serves and hearing stories of the success and achievements of their clients. When he's not optimizing the XYPN Invest client experience or sharing his vast wealth of Orion knowledge, Jeff steeps himself in music—he's played the piano for 25 years and enjoys listening to live music. He also stays busy being the "best dad ever" to his four young kids.