“Direct indexing” is a new term, but not a new practice.
“It’s a strategy that’s been around for a while,” Ben Hammer, head of client development for Vanguard Personalized Indexing, told a packed room at the Future Proof conference in Huntington Beach, California, earlier this week.
The audience was primarily made up of financial advisors eager to learn about this trendy topic. Advisors are Vanguard’s No. 1 client group; some 45% of Vanguard’s assets under management are held with advisors on behalf of their clients.
Hammer explained that direct indexing is essentially a separately managed account, or SMA, where a manager like Vanguard buys a collection of stocks tracking an index for an individual client. But unlike with an ETF or a mutual fund, Vanguard doesn’t buy every single stock within the index.
“You’re buying a handful so that you could have some tax loss harvest pairs. In direct indexing, you’re taking advantage of the dispersion of underlying stocks. Some of them are going to go up and some of them are going to go down every single year. You tax loss harvest much like you do with ETFs or mutual funds today, but you’ve supercharged it because you’ve got more tax lots available,” he explained.
In addition to those tax advantages, direct indexing provides the advantage of customization.
“You can pick specific things that you want to emphasize or avoid—ESG (environmental, social and governance) factors, individual securities, and what have you.”
The Role of Technology in Direct Indexing
Though direct indexing has been around for decades, it’s gaining traction now because it’s much easier to implement the strategy than it was before.
“The original [direct indexindg] players existed in an analog world,” said Ari Rosenbaum, director of Private Wealth Solutions at Canvas Custom Indexing.
“The space has [since] evolved to be able to deliver customization at scale. Technology is the key entrant into the evolution of the space. The ability to have the complete workflow—from creating investment models; linking new accounts to those models; being able to set tax budgets and do tax transition all online via portals that are connecting to the custodians— [makes] things more efficient for advisors,” Rosenbaum added.
Hammer agreed that “there’s new ways to add value to clients with a better technological platform.” Additionally, commissions and spreads of buying individual stocks have declined, making direct indexing more practical for a broader set of investors.
Direct Indexing’s Target Group
Still, despite being more accessible, direct indexing isn’t for everyone. If an investor is looking for tax optimization and customization, then direct indexing is “probably a good solution,” said Brandon Hass, head of direct indexing and model portfolios at S&P Dow Jones Indices. But if they’re looking for cost efficiency, “an ETP might be a better solution.”
Indeed, that certainly seems like how investors are currently using direct indexing. Hammer estimated that 80% of accounts using Vanguard’s direct indexing platform are there because they want better after-tax returns.
Advisors who use direct indexing “like indexing and everything it brings, but they want a little bit more for that particular client who might have a lot of capital gains in their life or one single investment that they’re going to be selling with a realized gain pretty soon,” Hammer said.
“Or maybe the advisor is intentionally putting them in things that have a lot of capital gains generated every year, like active mutual funds or private equity or hedge funds. So, in that case, the direct indexing account lives right along that other model and acts as an absorbent sponge that soaks up those gains,” he said.
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