Managers that provide the technology and services for direct indexing have been vocal about its benefits. They have been less direct, generally, in helping advisors understand where it works best – and where it may not be worth the cost and complexity.
But as more big asset managers jump into the direct indexing business, that’s begun to change in an effort to differentiate the service from their index ETFs and other cheaper, off-the-shelf options. Most recently, Vanguard has begun circulating a rough outline of the types of accounts that are good candidates for the service. Charles Schwab, for its part, has laid out a series of questions to help advisors profile the kind of client that could benefit from custom SMAs.
Despite growing financial media buzz about direct indexing, adoption remains low: just 12% among the advisors that Cerulli Associates surveyed late last year for a report commissioned by Parametric Portfolio Associates. Seattle-based Parametric, which is now mart of Morgan Stanley Investment Management, is the largest provider of direct indexing SMAs.
Awareness was one reason for the low figures; less than half of the survey respondents understood what direct indexing was.
Among those who knew about direct indexing, but didn’t use it, the main barrier to adoption appears to me a lack of motivation: 59% said they were satisfied with their current investment options.
Indeed, advisors across channels have been moving toward ETFs that provide some of the tax and cost benefits. After all, few equity ETFs pass off capital gains distributions, and the products can be used for year-end tax-loss harvesting of individual stock or active mutual fund holdings.
Direct indexing can amp up the tax-loss harvesting benefits by picking and choosing which individual stocks within an index to sell. But figuring out how big a benefit that can bring to a particular portfolio, relative to the effort of selling the concept to clients, may seem daunting.
Vanguard breaks it down for advisors with some easy-to-evaluate benchmarks, starting with a seemingly intuitive one: the client should be facing realized capital gains, and be using an account from which taxes on those gains must be paid (which all but eliminates from eligibility IRAs and workplace retirement plans, for example).
Ideal targets are portfolios that regularly throw off realized capital gains of at least 3% to 4% of a client’s taxable equity holdings each year, according to an August article from the Malvern, Pennsylvania-based fund giant. In addition, clients should have at least 20% to 30% of their financial wealth in taxable equities to be considered direct indexing candidates.
“For lower-net-worth investors, the tax efficiency of personalized indexing may not outweigh the additional cost and complexity,” the article notes.
Schwab similarly lays out attributes for clients that tend to benefit from the “tax alpha” direct indexing can provide, compared to traditional ETFs: those in higher income-tax rates, who benefit more from marginal tax savings; those living in high-tax states like California or New York; and investors who have a long-term buy-and-hold investment strategy for “a sizable portion of their assets.”
These guidelines highlight the relatively-tailored opportunity set for direct indexing – even if fractional trading and lower minimums make it possible for use in smaller accounts.