Q&A: How Financial Advisors Can Use Direct Indexing With Clients

Index funds are great starting points for many investors. They offer diversification, liquidity and low-cost options for quick and easy investing.

But when investors — especially wealthy investors — turn to financial advisors for guidance, they often want something a bit more personalized than a cookie-cutter index fund. After all, these funds may be low cost but they can’t give investors the control of a personalized portfolio of individual stocks.

Enter: direct indexing.

With direct indexing, investors bypass the index fund wrapper by buying the individual stocks in the index fund directly, effectively creating their own index fund. For example, rather than owning a share of an S&P 500 fund, a direct index investor would buy shares in all 500 of the companies in the fund.

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Naturally, this can create a cost barrier for many investors. Few people can afford to buy one share of every company in an index. This caused direct indexing to be an institutional strategy for many years. But now, with the advent of fractional shares — when investors buy a fraction of one share of a stock rather than an entire share — direct indexing has become more affordable. Financial advisors can employ the strategy with their retail clients.

To learn more about direct indexing in today’s markets, we spoke with Michael Blundin, chief technology officer at Vestmark and an expert on direct indexing strategies. He breaks down how financial advisors should approach direct indexing and which clients can benefit most from the strategy. Here are edited excerpts from that interview.

[Read: Q&A: Why Direct Indexing Is the Future of Index Investing.]

Why should advisors consider direct indexing for their clients?

Direct indexing offers better tax management than mutual funds and exchange-traded funds through the direct ownership of individual securities. This allows for not only the avoidance of distributed capital gains but also the proactive tax harvesting of offsetting losses against gains.

Direct indexing also presents an expanded opportunity for personalization. Clients can express their preferences and personal views in terms of social values, factors such as dividends yield or low volatility, or tilts like value or growth, as well as any personal restrictions in terms of industries or individual securities.

For which clients is direct indexing a good fit? Which clients would be better served with traditional index funds?

Historically, this kind of product was limited to institutional and ultra-high-net-worth clients, but technology and operational advances are increasing the availability of direct indexing products to all investors.

That said, client needs vary widely, and funds and ETFs will continue to have their place. For example, a smaller tax-exempt account might continue to be a good fit for these packaged products, and although the investor might lose the ability to express their personal investment preferences for environmental, sustainable and governance, or ESG, factors in the same tailored way that a personalized index-based separately managed account would allow, the total all-in cost of the portfolio might be less.

[Read: Q&A: Look Beyond International Index Funds.]

What are the biggest obstacles to direct indexing, and how can advisors overcome them?

Our industry is working to provide more sophisticated solutions and make investment products accessible to more people, but there continue to be technical challenges, such as fractional shares or hard-to-reach investment minimums.

There are also technology and educational challenges to incorporate ESG personal preferences and portfolio impact into dialogue between a financial advisor and client. Finding the simplest way to communicate and deliver what the investor wants is one of the challenges that technologists and advisors are trying to solve.

Advisors need to pay attention to platform capabilities. Tax optimization and personalization can be hard to scale, and understanding the impact of transaction costs in a personalized index-based portfolio is another challenge for advisors.

But the players in our industry are always on the lookout for innovative ways to generate additional revenue to counteract any transaction costs. From a diversification standpoint, an investor needs a portfolio that accommodates more investment strategies than just direct indexing to have a well-allocated distribution of assets, such as ensuring clients have access to the right fixed-income strategies.

How can advisors make direct indexing easier through automating workflows and tax lots?

Automating client data gathering and workflows can help advisors build customized products for each investor without the advisor having to ask numerous possibly cryptic questions. Technology — including building elegant client-facing portals that let clients input information and communicate and engage virtually with advisors — is helping to automate this process, making onboarding faster and easier on both clients and advisors.

Automation is also key in several other areas, such as building, managing and rebalancing personalized portfolios, as well as tax-loss harvesting, trading, rebalancing and reconciling.

What else do advisors look for when evaluating investment products for their investors?

For an investment product to be successful, it needs several things.

Firstly, the product itself needs to work from a regulatory perspective. The technology and platforms underneath the product need to make it run efficiently at scale.

Also, advisors need to be able to understand and sell the product and have the process be simple. And, ultimately, clients need to want it. There has to be demand.

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Q&A: How Financial Advisors Can Use Direct Indexing With Clients originally appeared on usnews.com

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