(NASDAQ) At least twelve major acquisitions by leading financial services firms have loudly signaled a major shift to and expansion of the direct indexing universe. Direct Indexing is not a new investment offering, having evolved from the managed accounts realm with its origins at the highest levels of High-Net-Worth wealth and tax management. But it is now another example of the continuing democratization of investment opportunities for a larger range of investors.
To better understand the evolution and implications of this fast-growing trend into direct indexing, we reached out to Institute member Dave Gordon, SVP of Direct Indexing at Vestmark – a leading provider of portfolio management/trading solutions that enable financial institutions and advisors to efficiently manage customized client portfolios through an innovative SaaS-based cloud platform. Their history of rapid and continuous innovation has enabled the multi-award-winning platform to deliver a streamlined solution for the management, trading and delivery of managed accounts that can propel wealth management firms to the next generation of digital investment solutions.
Hortz: What sparked this relatively new attention and active movement across the industry towards having direct indexing capabilities?
Gordon: I think there were really two main drivers: an increased client appetite for customization (driven largely by the rise of Responsible Investing) and an enduring interest in tax relief. Direct indexing in Separately Managed Accounts (SMAs) allows investors to track the performance of a recognized benchmark, tailor the content of their portfolios to their own beliefs and values and personalize their tax experience in ways that would not be possible with pooled investments like mutual funds and ETFs. The availability of technology is also making it possible for firms to offer these solutions in a scalable way to smaller clients, vastly widening the audience.
Let me share this Cerulli research release for more background information on direct indexing with growth projections.
Hortz: Unlike your firm Vestmark, why did most firms have to acquire the technology necessary to position themselves in this space?
Gordon: Direct Indexing requires much more granular client data – right down to individual tax lots of securities – than most asset management firms have traditionally maintained. Direct indexing is primarily about data management rather than investment management. We have long maintained the required level of detail in client accounts, which is why a number of other direct indexing offerings have relied on Vestmark’s portfolio accounting and trading engine.
This is really the key because we integrate true tax optimization into our portfolio accounting and trading processes so that our high-powered analytics can take full advantage of timely, accurate and granular data.
Hortz: Are there different strategies or approaches being applied in building and offering these various new direct indexing offerings? Any differentiators that need to be noted?
Gordon: Perhaps the biggest single differentiator is in the handling of substitutions that result from tax loss harvesting activities or from client customization requests. The simpler approach, favored by some direct indexers, is to invest the proceeds of such sales in sector or index ETFs for 31 days (to comply with wash-sale rules), then move back into the original security. Vestmark generally prefers a more robust portfolio optimization approach that replaces harvested securities with a new basket of securities that is expected to perform over the longer term like the harvested stocks.
Hortz: What is your firm’s vision and mission in the direct indexing space?
Gordon: We look at this space through a tech lens, more than an investment lens. We are constantly asking ourselves a two-part question: What aren’t our competitors doing, and why? If the reason they are not doing something is that it does not make sense or is not wanted by the market, then we do not need to worry about it. But if the reason they are not doing something is that it is hard, then that is something we would want to be known for doing first. We believe we can be the firm others want to emulate.
Hortz: Based on your research and substantial experience in this space, how do you see this direct indexing marketplace developing and evolving?
Gordon: Direct indexing seems poised to be the fastest growing equity “style” in the decade ahead. As more custodians adopt fractional share trading, direct index portfolios stand to benefit from tighter tracking errors and potentially lower minimum account sizes. Fees have already compressed to the point at which direct index accounts arguably “pay for themselves” in taxable accounts, making them even more attractive for taxable investors.
Hortz: Any key areas of concern from your perspective?
Gordon: As with any investment approach receiving heightened media attention, direct indexing can be misunderstood and sub-optimally employed. If an investor does not need tax management or customization (or both), then that investor does not need direct indexing and can find a satisfactory ETF or mutual fund solution. Additionally, direct indexing is not an area for dabbling; a direct index portfolio should be a core allocation of sufficient weight to generate meaningful tax losses. Moreover, the tax benefits have the greatest value to highly taxed investors and are less valuable to those in lower income brackets.
Hortz: Can you share any further thoughts or recommendations for advisors and investors on employing direct indexing into their investment portfolios?
Gordon: Make a direct indexing solution the core of your taxable equity portfolio with a 50-70% weight and choose the broadest index you are comfortable with rather than trying to blend multiple indices. Do not tinker with your direct index allocations – that is what alpha-generating satellite portfolios are for – but do adjust the portfolio during life-cycle events. Feeding the direct indexing portfolio with additional cash will help refresh cost basis and reinvigorate tax-loss-harvesting opportunities, just as funding liquidity needs with appropriate tax lots can improve tax outcomes.
We welcome advisors interested in separate accounts and direct indexing to visit our Knowledge Center page on our website where we share ongoing research, thought leadership, infographics, videos and advisor practice management issues addressing these topics.
The Institute for Innovation Development is an educational and business development catalyst for growth-oriented financial advisors and financial services firms determined to lead their businesses in an operating environment of accelerating business and cultural change. We position our members with the necessary ongoing innovation resources and best practices to drive and facilitate their next-generation growth, differentiation, and unique community engagement strategies. The institute was launched with the support and foresight of our founding sponsors – Ultimus Fund Solutions, NASDAQ, FLX Networks, Pershing, Fidelity, Voya Financial, Advisorpedia, and Charter Financial Publishing (publisher of Financial Advisor and Private Wealth magazines).
