Client Conversations: Explaining Direct Indexing

We know that clients may be reacting to an unusual and what feels to them uncertain investment market with a range of emotions. Some may have become more risk adverse, others may feel that now is a time to increase their investment monitoring. And there may be clients who think now is a great time to find undervalued assets to invest in, though, those last folks may be rare. This new phase may be a continuation of unusual circumstances. Advisors have been helping clients with these circumstances for, well, years. Since the volatility at the start of the global pandemic, in March of 2020, advisors have tackled increasing amounts of new clients, higher amounts of clients transitioning to retirement, and many clients who have lost positions and may have been unemployed. We’ve been providing articles on how to help clients during this period. As part of that, we think helping clients understand direct indexing will be beneficial for some of them.
‍

You may remember that we’ve discussed a few aspects of passive investing recently. There we said “Index funds and passive investments may have fallen from investors’ favor over the last few years for a few reasons. One may be that during the pandemic, index funds may have seemed unable to address the volatility of a market that first faced a global health crisis and crippling supply-chain shortages and then faced massive hits to commodities markets due to the Russian aggression towards Ukraine. But index funds, robo or otherwise, and their close cousin target date funds shouldn’t go the way of the baby in the bathwater.”^[1]
‍

We think there are four main points of confusion for clients around direct indexing. First, clients may be confused about direct indexing and index funds. Because they sound similar, clients may think they know the subject already. We think this succinct statement from Charles Schwab puts it most clearly. “Whereas traditional indexing attempts to replicate the performance of an index via an ETF or indexed mutual fund, direct indexing mimics the performance of an index by directly holding select securities within the index.”^[2] Advisors may want to use a specific asset or stock in a client’s portfolio as an example of the difference. Many clients hear of direct indexing associated with ETFs, in the sense of them being an alternative to ETFs. Since many clients may want to make a turn entirely from the ETF concept, they may put direct indexing into the same bucket as ETFs and walk away from them. Distinguishing these concepts may be important to clients.
‍

Second, clients may think direct indexing is not available to them due to total assets or available investments. It was true that direct indexing was previously only available for larger investing. However, changes to investing, like commission-free trading and fractional shares, as well as a drop in investment minimums for direct indexing may have changed who can participate. “In the past, direct indexing would require a relatively significant amount of money to buy all of the stocks in a particular index needed to replicate its performance.”^[3] That breadth of stocks also meant an increase in trading and commission costs if rebalancing and reconstituting were needed. Some direct indexing is lower, but still may involve too many assets for clients, such as accounts that require minimums of $100,000-$200,000. However, recently Fidelity now offers direct indexing for $4.99/month. It is not clear yet whether that will create similar programs at other brokerages. However, some experts in the field think there will be a growing movement towards availability. “Ben Johnson, director of global exchange-traded fund research at Morningstar… expects direct indexing will become more available over time given the acquisitions of direct indexing firms by major asset managers. Over the past year or so, Schwab acquired Motif; BlackRock purchased Aperio; Morgan Stanley bought Eaton Vance, which owns Parametric; and, most recently, Vanguard announced a definitive agreement to acquire Just Invest.”^[4]
‍

Third, there are tax issues clients should consider. This includes capital gains. Some experts suggest that direct indexing “makes sense only for taxable accounts, since tax-loss harvesting is one of its key benefits and is often available to those accounts held by high-net-worth or ultra-high net worth clients.”^[5] Clients should always consult with their tax advisors concerning maximizing their tax benefits (or minimizing tax risks).
‍

Fourth, some industry analysts are forecasting that direct indexing will attract assets at a faster pace than EFTs or other funds. This growth may have some advisors unprepared for client who are hearing about direct indexing through means other than their advisor. “Cerulli Associates finds that only 14% of financial advisors are aware of, and recommend, direct indexing solutions to clients.”^[6] If the forecast proves to be accurate, that could mean clients learning inaccurate information or seeking inappropriate investment options, ones that don’t meet their long-term needs. Advisors may want to make clear that they are open to discussing whether direct indexing is an optimal selection for clients, as a way to start conversations.
‍

Additionally, clients may not know that direct indexing options now allow for customization. As many investors have begun to be aware of the power of shareholders and investing, and ESG investing in general, they may be wary of direct indexing based on older notions of that were less flexible about customization.

‍

‍

‍

‍

^[1] https://www.bcgbenefits.com/blog/passive-investing

^[2] https://www.schwab.com/learn/story/is-direct-indexing-right-you#

^[3]https://www.fidelity.com/learning-center/trading-investing/direct-indexing

^[4] https://www.thinkadvisor.com/2021/08/17/the-drawbacks-of-direct-indexing/#

^[5] https://www.thinkadvisor.com/2021/08/17/the-drawbacks-of-direct-indexing/#

^[6] https://www.etf.com/sections/index-investor-corner/allan-roth-direct-indexing-better-etfs

‍

‍

‍

‍

‍

‍

‍These articles are prepared for general purposes and are not intended to provide advice or encourage specific behavior. Before taking any action, Advisors and Plan Sponsors should consult with their compliance, finance and legal teams.

‍