Direct Indexing

Direct Indexing is just hitting its stride in the advisory space, but it has already come a long way from where it began.  Today the term is used for a series of applications, but as one of the original TAMPs to add direct indexes onto a model marketplace (we now offer well over a hundred), it makes sense to explore the original concept and where we are today.

Where it Started

Direct indexing originated with the idea of being able to have the same return as a broad market index.  However, there was the large burden of having to purchase the requisite number of securities and maintain them in the same profile as the indexes. While this already existed in the form of having an index in a SMA, it typically included high minimums and significant fees. Investable products were also created such as ETF derivatives (DIA for the Dow Jones and QQQ for the NASDAQ, for example), but the structure limited the ability to utilize the broad market exposure to maximize after-tax returns (tax harvesting). As the products were traded in the open market, it also ran the risk of temporarily decoupling from the underlying index’s return. Once technology caught up, including aspects like fractional shares,  it made it much easier for firms to own all the securities in the index without having to use factoring or some other method to try to achieve the same return with less securities than the index.

One of the main drivers behind all this was to achieve the same return as the index itself without being subject to the additional fees and pricing issues of a derivative product.  Another driver was the ability to tax harvest.  As advisors already had allocations to a broad range of either third-party or internal strategies, their clients had exposure to positions being actively bought and sold over the course of the year. This created realized long term and short term gains and losses. Now that the same investor also held many of those securities in a direct index allocation, tax harvesting began to take a major role in improving a client’s after-tax returns.  

Where it Is

We have since seen an explosion of direct indexes coming out.  It started with the major indices providing a direct index version of their own index.  Then it became more sector-oriented, enabling exposure to a subset of the broad index.  Since then it has expanded to take into account just about every kind of subsector.  From giving clients exposure to the cannabis industry’s upstream supply chain to ideological themes like a Vegan Index, direct indexing is becoming a turnkey way for advisors to gain exposure to niche areas of the market and provide investment managers with a quick-to-market solution that, because it they are so heavily rules-based, did not require the same level of due diligence for many investors.  These same firms also offer a custom solution that provide exposures to the broad markets but without certain stocks, whether they be ‘sin’ stocks or simply more inclined to an ESG mindset.

SMArtX helps advisors to maximize this aspect of their direct indexing initiatives by providing a tax harvester where the book of record is kept at the sleeve level.  This level of detail provides information on individual tax lots and enables advisors to chose exactly what they would like to harvest.  Of course every tax harvest is monitored for wash sales across the account and household, and advisors are able to dictate what happens during that period and once it is over. 

What’s Next

At this point we are seeing early days of the Direct Indexing movement.  The use of fractional shares is not widespread across the industry but are sure to change the way advisors manage client accounts. New technologies are also seeing more customized, ‘do-it-yourself’ solutions but without a proper skill set or background in creating indexes, it is not as easy as it may sound.  However we see the industry develop, it seems they are here to stay and are playing an increasingly important aspect in the administration of managed accounts.