If you’ve been curious about direct indexing and whether it’s a good fit for your clients, you’re certainly not alone. This investment strategy, once exclusive to high-net-worth individuals, has become more accessible in recent years, with advisors offering it at lower fees and minimums.
Investor interest is on the rise, as shown by the Charles Schwab ETFs and Beyond Study 2023, which revealed that over half of Boomer ETF investors have heard of direct indexing, and 22% are extremely interested in learning more about it—an increase from 16% in 2022. Younger generations show even higher levels of awareness and interest, indicating that direct indexing will likely become a more prominent topic in the future.
For those still unfamiliar, direct indexing involves separately managed accounts that aim to mimic the performance of an index by purchasing a subset of its stocks. This approach offers greater control and customization compared to index ETFs or mutual funds, allowing investors to exclude specific companies or sectors while maintaining broad market exposure.
Direct indexing can potentially provide significant tax benefits and opportunities for personalized investing. However, it may also introduce complexity and might not suit all clients, especially those who prefer the simplicity of index ETFs or mutual funds.
So, how do you determine if direct indexing is right for your clients? Consider these five questions:
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Is the client sensitive to taxes? Clients in higher tax brackets may benefit from direct indexing due to tax-loss harvesting opportunities, which can reduce their overall tax burden by offsetting gains elsewhere in their portfolio.
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What is the client’s time horizon? Direct indexing is often seen as a long-term strategy, particularly beneficial for investors with a three- to five-year horizon, as it allows for the compounding of potential tax advantages.
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Does the client have concentrated stock holdings? Direct indexing can be advantageous for clients with concentrated stock positions, as it enables them to diversify their portfolios and mitigate concentration risk by excluding specific stocks or sectors from their index.
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Is the client interested in aligning investments with personal values? Direct indexing offers the flexibility to exclude certain securities or industries, allowing investors to align their portfolios with their values by avoiding investments in areas they find objectionable.
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Does the client engage in charitable giving? Clients with direct indexing accounts can donate appreciated securities to charities, potentially receiving tax deductions for the current value of the stock while avoiding capital gains taxes. This strategy can result in significant tax savings for large gifts.
While direct indexing may not be suitable for all clients, its after-tax benefits can be substantial for those it does fit. Offering personalized investment opportunities can also set advisors apart. By asking the right questions, you can determine whether direct indexing aligns with your practice and your clients’ needs.
