Direct indexing continues to gain popularity as investors look for customized options and demand lower costs. Direct indexing, which involves owning a representative amount of securities in an index versus a mutual fund or ETF, can have a number of benefits – including potentially reduced costs, individual ownership of tax lots and increased efficiency tax, at the top of the examination for personal persons. preferences and greater personalization of the portfolio.
However, it is not enough just to implement direct indexing – it is how you implement it. While many advisors are currently using or looking to use direct indexing, a large percentage may be missing out on helping their clients reach its true potential. This is because we often see advisors or asset managers implement an indexing strategy within an SMA or as an independent advisor model, also sharing the client with other managers in different accounts. This is underselling the strategy's true potential for several reasons.
To “supercharge” direct indexing, it needs to be delivered to a single multi-manager account via a unified managed account framework to help realize its full benefits, something that only 2% are doing of direct indexing assets, according to Cerulli. This allows a live index to be placed at the core of an account, with satellite holdings wrapped around it, which has a number of benefits for both client and advisor.
Cost savings from Alfa tax submission
Direct indexing can be a great way to incorporate tax loss harvesting, which can help investors generate tax alpha, even in the midst of severe market swings. Investors can access opportunities to harvest capital losses at the individual security level, while still maintaining consistent exposure to the benchmark index. This can allow direct indexing to produce similar pre-tax returns as an ETF strategy, but with short-term realized capital losses.
However, if this is only being done in a stand-alone SMA, with additional managers held in other account records, there is no way to manage wash sales across the entire portfolio, nor the transfer of holdings in and out of the core, nor proper determination over and over again. the weigh-ins. Simply put – one hand will not know what the other hand is doing. If a client's portfolio is spread over different managers in separate accounts, you cannot see over the “walls” that these account numbers create. An advisor or manager can make a smart shift in a taxable portfolio, but unforeseen tax consequences can occur if assets are spread across different accounts.
This often results in prohibitive losses due to wash selling and actually ends up penalizing the investor. Often, the full impact of disallowed losses is not recognized until presented by the custodian at the end of the year or when your client is working with the tax preparation professional—someone that advisors want to rely on for business development purposes.
Management of Core-Satellite Allocations
Many advisors choose to use a basic satellite approach to building a portfolio – creating a “core” allocation of low-cost, indexed solutions in efficient asset classes and “satellites” of actively managed investments in inefficient classes of assets to seek excess return. The advisor can work with the client to tilt the indexed core toward their goals and preferences. Doing this within a UMA allows the entire allocation to be managed in a single account to facilitate efficient rebalancing, asset allocation changes and additions, and cash management.
Additionally, investors and advisors can reduce administration overhead with just one portfolio to manage, cutting down on the time and hassle of keeping track of investments across multiple locations.
Reduction of capital gains on assets of separate inheritance
When they switch firms, many advisors force the clients they're bringing to sell their positions and start over on the new platform, which can cause significant capital gains taxes for those clients. Detached advisors can work with a provider to build a live index within a UMA, resulting in the portfolio seeing lower turnover and trading activity by absorbing holdings from a satellite manager into a live index.
Direct indexing can have multiple benefits for clients. But when not implemented in a UMA, many of those benefits can be lost. Keeping everything in one place can create better results for clients while saving advisors from administration headaches.
Barrett Ayers is the CEO of Adhesion Wealth