“Black goes with everything.” We’ve probably all heard that fashion rule of thumb and may even follow it ourselves. Yet the problem with being one woman in a crowd of many all wearing black dresses (or a man in a crowd of men all wearing black suits) is that it’s very difficult to stand out (hence the need for bling!) A similar issue – and solution – is at play in the rise of direct indexing, labelled by some as the “hot new investment strategy.” As more and more financial services companies offer direct indexing to a wider group of investors, they will face the challenge of differentiating their offering – their little black dress, if you will – from the sea of others.
Direct indexing is just what it sounds like: investors buy shares of the stocks that make up an index, in the same weights as the index, rather than investing in an index mutual fund or exchange-traded fund (ETF) that tracks the index. For example, if replicating the S&P500, the investor would directly own all the stocks in the index.
Done well and with attention to detail, direct indexing gives investors some tax optimization techniques and the agility to track the index BUT with a degree of customization, as managers can manage the portfolio, rebalancing it when needed. With these potential benefits, it’s no wonder that Cerulli Associates is forecasting that direct indexing will grow at an annualized rate of more than 12% over the next five years, faster than mutual funds, ETFs, and separate accounts.
One factor driving this growth is that direct indexing is becoming available to a wider range of investors than ever before. Since it’s usually expensive to buy all the stocks in an index, direct indexing traditionally has been used only by ultra-high-net-worth (UHNW) investors, as they tend to have bigger portfolios than less wealthy investors have. However, two things have broadened the market for this strategy: the rise of commission-free trading and fractional share stock investing. Meanwhile, asset managers are responding to this momentum by acquiring direct indexing providers, introducing their own proprietary solutions, and applying direct indexing to new asset classes, according to Cerulli.
As more and more providers offer this strategy, the challenge for managers will be differentiation. It’s the “little black dress” conundrum. Sure, a little black dress is a useful wardrobe item but, when it comes down to it, it looks like any other little black dress unless there’s something extra about it that really stands out.
So how then can managers make their little black dresses and black suits – their direct indexing solution – stand out?
The key, as always, is in the detail. A skilled manager will be able to tread the fine line between making the most of tax controls and optimizing the portfolio while not straying too far from the index.
Advanced tax control, for instance, is direct indexing’s friend, with tax-loss harvesting serving as the primary tool. This strategy involves selling holdings that are at a loss to help offset other gains. Not everyone can benefit from tax loss harvesting. In 2021, investors who earn $40,000 or less aren’t on the hook for long-term capital gains taxes, for example, and tax-advantaged retirement accounts don’t count either.
There’s also no guarantee that the losses will be greater than the tax liability you want to offset, which means the success of this tool relies largely on the skill of the manager. But that’s the good news, not the bad, as being skilled at this form of tax control is one way that managers can differentiate their direct indexing solution from the competition.
Direct indexing’s second cheerleader lies in customization, something that investors are demanding as standard these days. Here, again, lies an opportunity for managers. The more you can customize your direct indexing solution to an individual investor’s unique desires and needs, the more you can differentiate your offering from just any direct indexing strategy.
The inherent problem with both customization and tax loss harvesting is that your version of the index might start to look a lot different from the actual index; you end up with a tracking error. You aren’t direct indexing anymore; you are looking at a bespoke portfolio instead. So, one of the most important decisions an investor needs to make upfront is how much of a tracking error they can put up with and how that works with what they are trying to do more broadly.
That’s where the best advisors can truly stand out, as they will have a view on whether direct investing is actually worth doing in the first place, as well as the wherewithal to successfully navigate investors through the process and say whether the additional complexity and fees involved are worth it.
And so, as direct indexing “becomes the new black,” merely just offering a direct indexing solution will not be enough for providers to differentiate their solutions from the competition. Instead, as any good fashionista knows, they need to provide some bling. No, not a nice necklace or an eye-catching belt, but rather advanced tax controls, customization, and on-point messaging.
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November 22, 2021 at 09:29PM
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Is Direct Indexing The New Little Black Dress? - Forbes
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