If you’ve found yourself wondering about direct indexing and whether you should consider offering it to your clients, you’re likely not alone. What was once a niche investing strategy available only to the high net worth has evolved in recent years, becoming widely available through advisors and at more approachable fees and minimums.
Accordingly, investor awareness and interest are picking up. Charles Schwab ETFs and Beyond Study 2023 found that just over half of Boomer ETF investors have heard of direct indexing and 22% are extremely interested in learning more about it (up from 16% in 2022). Younger generations have even higher levels of awareness and interest, signaling that direct indexing is going to become a bigger part of the conversation in the years ahead.
For those who are still unclear on exactly what direct indexing is, a quick explainer. Direct indexing portfolios are separately managed accounts that aim to track the performance of an index by buying a representative subset of stocks. It is for core, taxable equity investments. Directly owning the stocks offers the opportunity for greater control and customization compared with an index ETF or mutual fund. Specific companies or even entire sectors can be removed while still providing the investor with broad exposure to the market.
Direct indexing has the potential to provide compelling tax benefits and opportunities to help clients invest in a more personalized and tailored way. On the flip side, it can add complexity and might not be as beneficial for some clients, where the simplicity of index ETFS or mutual funds may be a better fit.
So, how do you decide if direct indexing can add value for your clients? Start by asking these five questions:
1. Is the client tax-sensitive?
Investors in higher tax brackets may benefit from direct indexing. Compared with index ETFs and mutual funds, directly owning the securities within an index can create opportunities for tax-loss harvesting (selling securities at a loss to offset gains realized elsewhere in an investment portfolio, reducing their overall tax burden).
Tax-loss harvesting provides benefits through both an immediate reduction in tax liability (realized) and the delaying of tax liability (unrealized).
Investors with capital gain exposure, either from appreciated stocks they own or real estate, could also use direct indexing to offset those gains through tax-loss harvesting.
2. What is the client’s time horizon?
While direct indexing can be part of a diversified portfolio in different ways, many investors are likely to see direct indexing as a core, long-term strategy. Long-term investors with at least a three- to five-year time horizon may benefit more from the compounding of potential tax alpha. This is simply the value created in a portfolio through tax management.
3. Does the client have a concentrated stock position?
Consider a client who spent their career working in biotech and holds a significant amount of stock accumulated through corporate stock plans and incentives. The advisor wants to help this investor get exposure to a broad stock market index while reducing their concentration risk. Direct indexing can be helpful in these scenarios because it allows investors to exclude stocks – or even an entire sector – from a chosen reference index. This results in an overall portfolio that is more diversified and less weighted toward a specific sector.
In addition, the tax-loss harvesting may allow them more flexibility to divest accumulated stock by offsetting capital gains.
4. Is your client interested in aligning investments with their personal values?
Index-based strategies offer broad-based diversification, but some investors want their investments to reflect their personal values which could mean avoiding investments in companies involved in tobacco products, gambling, fossil fuels, weapons manufacturing, or other areas. The ability to exclude securities or industries in direct indexing can help investors better align their portfolios with their personal values. Investors can still get many of the benefits of index investing, but in a more tailored way that suits their personal values.
5. Does the client give to charities or plan to in the future?
Rather than writing a check to a charity, clients in direct indexing accounts can donate individual securities that have appreciated the most for charitable giving. The client may receive a tax deduction (if certain requirements are met) for the current value of the stock, and no capital gains taxes are assessed on the appreciation.
Additional Reading: Affluent Women Influence 85% of Charitable Giving Decisions
The check your client would have sent to charity can then be invested into the direct indexing account. The newly purchased securities have no built-in capital gains like the donated securities, which could decrease the investor’s future tax bill when they sell those stocks. For large gifts, this could mean thousands of dollars in tax savings.
Direct indexing isn’t for all clients, but when it fits, the after-tax benefits can be significant. Offering the opportunity for personalization can also be a real differentiator for advisors. Asking the right questions on behalf of your clients will help you determine if direct indexing makes sense for your practice and your clients.
Dennis Hudachek is a director, product management, and D.J. Tierney is a senior investment portfolio strategist, both supporting Schwab Asset Management.
