WA MAGAZINE JanFeb PDF A - Flipbook - Page 28
DIRECT INDEXING
Advisors Talk, We Listen:
The Future of DI
Now that the market structure has shifted, owning individual
securities makes sense again. Technology eliminated the
complications. But what kind of help do advisors want, and
where are they going to get it?
irect indexing allows wealth
managers to replicate the
performance of an index like
the S&P 500 or the S&P U.S.
Aggregate Bond Index by
purchasing the individual securities that
make up that index. Traditionally, investors use mutual funds or ETFs to track an
index, but with direct indexing, you buy a
proportional amount of each stock within
the index. This means a client portfolio
can closely mimic the index’s performance while allowing for customization.
Until recently, this approach required
a significant amount of capital because
buying all the individual stocks in an
index was expensive and imprecise.
Transaction costs were high. In the ab-
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sence of fractional holdings, weights got
skewed and tracking errors multiplied.
And this was only to build the portfolio:
rebalancing positions to keep in line
with the index’s changes also carried
high trading costs. This complexity limited the strategy to wealthier investors
whose advisors had the intellectual and
organizational resources to keep up.
However, several changes have made
direct indexing more accessible. Fractional holdings allow investors to purchase
stocks and even bonds in smaller lots,
making it easier to replicate an index
precisely without needing large sums
of money. Also, the growing availability
of zero-commission trades has reduced
the costs of rebalancing and adjusting
portfolios, enabling more advisors to
consider this approach without creating
unnecessary drag for their clients.
A key benefit of direct indexing is
the ability to personalize client holdings.
Unlike ETFs or mutual funds where a
third-party manager selects and weights
the securities in the portfolio, direct indexing lets you deviate from the model
to achieve differentiated outcomes.
This flexibility also allows for shortand long-term tax optimization, reopening traditional opportunities to harvest
tax losses and generate meaningful
post-tax returns over time. The power to
outperform the underlying index after
the IRS and state authorities have taken
their cut is precious to many advisors
whose clients can recognize the added
value instantly.
Direct holdings also enable advisors
to allocate around concentrated exposure and legacy positions, integrating
the client household’s history into the
forward-looking investment program for
true diversification and a more efficient
approach to the efficient frontier.
Finally, a direct approach creates
opportunities that go beyond raw investment performance. Exposure to fixedincome securities in a pooled portfolio
prevents principal return on maturity,
for example, whereas even fractional
direct holdings provide the psychological
comfort and fiscal cushion that bonds
have historically supported. And when
the client responds to extra-financial considerations (
