Direct Indexing 101: Satisfying Today's Demand for Greater Personalization
Key takeaways
- Investment strategies that are tailored to the unique needs of investors have historically been out of reach for all but the wealthiest investors.
- Advancements in technology and portfolio software have democratized access to these personalized portfolios through direct indexing, an innovative strategy that is redefining the competitive landscape for financial advice.
- With direct indexing, since investors own the individual securities instead of a co-mingled fund, any losses that are taken on declining securities belong to investors.
Introducing a New Client Experience
Investment strategies that are tailored to the unique needs of investors have historically been out of reach for all but the wealthiest investors. Instead, most individual investors have opted for off-the-shelf exposure, turning to mutual funds or ETFs to build out their investment portfolios.
Now, advancements in technology and portfolio software have democratized access to these personalized portfolios through direct indexing, an innovative strategy that is redefining the competitive landscape for financial advice.
As this technology becomes more widely available, it is driving a shift in client expectations too. Clients, particularly those in younger generations, are now coming to expect greater levels of personalization within their investment portfolios, with preferences that are harder to fulfill with one-size-fits-all strategies. Younger investors may also have an interest in investment vehicles that can offer benefits such as tax efficiency1 and values-aligned2 investing. As these generations continue to grow their level of wealth in the coming years, this has the potential to drive even more assets into personalized strategies.
Emphasizing this shift in consumer expectations and preferences, direct indexing assets are projected to grow at a faster pace than traditional financial products such as ETFs and mutual funds over the next several years.3
So, What Exactly is Direct Indexing?
Direct indexing provides access to many of the same areas of the market that mutual funds and ETFs do; however, it differs from these traditional financial products in an important way. Rather than owning shares of the mutual fund or ETF, direct indexing gives investors the ability to directly own shares of the benchmark constituents, with the ability to exclude individual holdings.
It is this direct ownership of the underlying holdings that gives investors more control and flexibility. Owning individual stocks provides the potential to reflect the characteristics of an index while at the same time, offering ongoing tax-loss harvesting as well increasing personalization aligned to their objectives. These features make the most sense for the distinct needs, preferences and financial goals of investors. As such, a wide range of investors may value the capabilities offered by this technology.
A few prominent examples include:
- An investor who wishes to avoid investing in companies that are directly involved in the production, distribution or sale of products that do not align with their beliefs,
- An investor that wants greater tax-management capabilities with the potential of improving after-tax returns, or
- An investor who owns a concentrated position in a single stock—such as from an employer— and doesn’t want to add to this exposure.
In all these cases, direct indexing can provide the degree of control and personalization necessary to solve each of these challenges and improve client outcomes.
A consideration investors interested in a direct indexing strategy should keep in mind is that separately managed account (SMA) portfolios like direct indexing generally have higher investment minimums compared to ETFs and Mutual Funds. Additionally, as direct indexing portfolios can be 100% equity-based, they may only be appropriate for investors with a high risk tolerance who are prepared for some deviation from their chosen benchmark upon customization.
How Does This Work in Practice? What Does the Client Experience Look Like?
Investors create this personalized portfolio by beginning with an index that offers exposure to the desired area of the market, with the option of excluding a specific sector or security from the index. With direct indexing, since investors own the individual securities instead of a co-mingled fund, any losses that are realized on declining securities belong to investors. Then, investors can use those losses to offset the gains on their federal tax returns, which can be extremely helpful in reducing their tax bills.
Tax-efficient transitions and gains-realization deferral along with tax-loss harvesting of individual securities within the index can give investors more opportunities to generate higher after-tax returns. The result of these tax-efficient strategies is known as "tax alpha."
Automated tax-aware portfolio rebalancing also has the potential to add ongoing value. Direct indexing offers the best of both worlds: it provides the investor with index-like returns but with a focus on after-tax wealth maximization. Given the current macroeconomic environment and level of volatility, lower expected returns and potentially higher tax rates in the future make direct indexing an attractive option to consider.
Beyond these, for those investors who wish to customize a portfolio based on their environmental, social, and governance (ESG) preferences, industry-leading data from Morningstar Sustainalytics can help identify companies whose values align with those of the investors.
Performance reporting that shows pre- and post-tax returns relative to the index, adherence to risk guidelines and ESG risk ratings give investors an ongoing view of their investment as well as the impact of their specific personalization needs.
These capabilities, informed by Morningstar’s depth of research and expertise, can help seamlessly deliver transparent, personalized and tax-efficient investing options for your clients and support the scale and growth of your practice.
Take Action
Interested in learning more about Morningstar Direct Indexing? Contact your local sales representative, email mp@morningstar.com, or call 1-877-626-3227.
References
1. Five financial truths about Millennials at 40, Natixis, 2022
2. Sustainable Signals: Individual Investors and the COVID-19 Pandemic, Conviction and Choice, Morgan Stanley, October 2021
3. Improving Client Experience: Customizing with Direct Indexing, Cerulli Associates, August 2021
Opinions expressed are as of the current date; such opinions are subject to change without notice. Morningstar Investment Management shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. This commentary is for informational purposes only. The information, data, analyses, and opinions presented herein do not constitute investment advice, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment. Performance data shown represents past performance. Past performance does not guarantee future results. All investments involve risk, including the loss of principal. There can be no assurance that any financial strategy will be successful. Morningstar Investment Management does not guarantee that the results of their advice, recommendations or objectives of a strategy will be achieved. This commentary contains certain forward-looking statements. We use words such as “expects”, “anticipates”, “believes”, “estimates”, “forecasts”, and similar expressions to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to differ materially and/or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason. Past performance does not guarantee future results. Morningstar® Managed PortfoliosSM are offered by the entities within Morningstar’s Investment Management group, which includes subsidiaries of Morningstar, Inc. that are authorized in the appropriate jurisdiction to provide consulting or advisory services in North America, Europe, Asia, Australia, and Africa. In the United States, Morningstar Managed Portfolios are offered by Morningstar Investment Services LLC or Morningstar Investment Management LLC, both registered investment advisers, as part of various advisory services offered on a discretionary or non-discretionary basis. Portfolio construction and on-going monitoring and maintenance of the portfolios within the program is provided on Morningstar Investment Services behalf by Morningstar Investment Management LLC. Morningstar Managed Portfolios offered by Morningstar Investment Services LLC or Morningstar Investment Management LLC are intended for citizens or legal residents of the United States or its territories and can only be offered by a registered investment adviser or investment adviser representative. Investing in international securities involve additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may increase these risks. Emerging markets are countries with relatively young stock and bond markets. Typically, emerging-markets investments have the potential for losses and gains larger than those of developed-market investments. A debt security refers to money borrowed that must be repaid that has a fixed amount, a maturity date(s), and usually a specific rate of interest. Some debt securities are discounted in the original purchase price. Examples of debt securities are treasury bills, bonds and commercial paper. The borrower pays interest for the use of the money and pays the principal amount on a specified date. The indexes noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since indexes and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Management cannot guarantee its accuracy, completeness or reliability. Sustainalytics is an environmental, social, and governance and corporate governance research, ratings, and analysis firm. Morningstar acquired Sustainalytics in 2020. Sustainalytics provides ESG scores on companies, which are evaluated within global industry peer groups, and tracks and categorizes ESG-related controversial incidents on companies. Morningstar uses Sustainalytics’ company level ESG analytics to calculate ratings for managed products and indexes using Morningstar’s portfolio holdings database.
An Inside Look at Direct Indexing
Direct indexing is becoming a key addition to financial advisors’ toolkits. It provides the ability to tailor an index, like removing a stock or even industry, which can bring the fun back to investing and help with after-tax outcomes.So, what’s all the fuss about? What are the salient points you need to know? Who’s it right for? And what are the thorny issues to weigh?