(Forbes) - Whether it be shoes, phone cases or coffee mugs, the age of personalization is upon us. Not only is getting something off-the-shelf now almost considered a faux pas, but it also leaves you asking yourself, “Could this better suit my needs?”
The same principle now applies to financial planning. Today’s investors want their portfolios tailored to them but don’t want to pay more for the privilege. Therein lies the issue at hand: How can financial advisors provide their clients with optimized portfolios but also be sensitive to their unique tax needs while personalizing to reflect their clients’ values and beliefs? One option to consider is direct indexing, an index investing strategy that involves replicating an index by buying a representative amount of the index’s components individually.
Put simply, direct indexing is personalization at scale. With greater portfolio customization, financial advisors can offer a number of benefits to their clients when compared to portfolios consisting of mutual funds or ETFs that track an index. Here’s how direct indexing strategies powered by next-generation technologies can lead to future-ready portfolios.
Optimized Exposure To Fixed Income
The standard 60/40 portfolio has taken its lumps as we persist in a low-interest-rate environment. In fact, if inflation continues along this path, a dollar today will buy $0.95 of goods next year and only $0.77 worth of goods in five years with the current rate of inflation. Historically, personalized bond portfolios have required substantial sums of money and been reserved for high-net-worth investors and institutions.
By applying direct indexing to a client’s fixed-income holdings, financial advisors can find yield in a world when investors have struggled to find a fixed-income solution.
Higher After-Tax Returns
In a time when financial advisors are increasingly challenged to demonstrate their value to their clients, there can never be too many ways for them to show that they are exhausting all options to provide better returns. Direct indexing provides financial advisors opportunities to increase the tax alpha in client portfolios.
For clients who have taxable accounts, such as a brokerage account at a custodian, financial advisors can use tax-saving strategies, such as tax-loss harvesting—the selling of securities at a loss to offset capital gains—to maximize after-tax returns.
More Personalization
Perhaps you are socially conscious and want to invest in companies that share your environmental, social and governance (ESG) values; a faith-based investor morally opposed to vice and sin stocks; or you work at a publicly traded firm company and are overweight with a single stock.
Direct indexing offers financial advisors a solution without losing sight of the benchmark that you have identified for your investments. Technology solutions available today provide tools and models that enable greater customization rather than blindly buying an ETF or mutual fund.
Reduced Overlap In Portfolio Holdings
Today’s portfolios consist largely of mutual funds and ETFs that have many of the same large-cap stocks as core holdings. You know the names: Apple, Microsoft, Amazon, Alphabet, Facebook, Tesla and so on.
By applying direct indexing technology to a client’s portfolio, financial advisors can reduce overlap in holdings, providing greater transparency into a client’s exposure to a given sector and enabling broader diversification across portfolio holdings.
Remaining Invested Longer into Retirement
Record numbers of Boomers retiring, while Gen-X and millennials enter their prime earning years. Achieving portfolio income goals while still allowing an investor’s portfolio to generate returns is a balancing act for many financial advisors. Direct indexing, specifically in a client’s fixed-income holdings, could help financial advisors keep their near-retiree and retiree clients invested in the market as they transition from accumulation to decumulation phase.
How To Get Started With Direct Indexing
If you’re intrigued by the potential of direct indexing to transform client portfolios, it’s important to understand your goals and whether you want to work with a technology provider that’s tax-focused, allows for more personalization, creates customized portfolios, builds rules-based strategies or some combination of those. Your intended strategy will inform which vendor will be the best fit for your specific needs.
Michael Kitces, on his Nerd’s Eye View financial planning industry blog, does a deep dive on the four types of direct indexing and the technology providers currently in the market to help you determine the right solution for your firm, which offers a great primer on what to consider when starting with this strategy. Like your client portfolios, there is no one-size-fits-all approach, so it’s important that you understand the technology solutions that are available to you and how they match up with client needs.
Financial planning, at all stages of life, is paramount. But so are optimized portfolios. To help achieve a client’s goals and desires as an investor, financial advisors should consider how to prioritize personalization and build better client relationships.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
By Adam Green | Forbes Councils Member
Mar 31, 2022
Adam Green is the co-founder and CEO at YieldX. Adam also co-founded and was the Chief Strategy Officer at MoneyLion.
