Direct Indexing 101: Satisfying Today's Demand for Greater Personalization
- 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.
Interested in learning more about Morningstar Direct Indexing? Contact your local sales representative, email firstname.lastname@example.org, or call 1-877-626-3227.
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
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