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Types of Direct Indexing Solutions for Advisors

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A financial advisor using a direct indexing provider to implement custom strategies for her clients.

Direct indexing is an investment strategy that aims to replicate the performance of a stock index by investing in the underlying securities that the index is composed of. Assets are held in a separately managed account which can open the door to greater tax efficiency through loss harvesting. Advisors may turn to direct indexing providers for tech solutions to implement custom strategies for their clients.

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How Does Direct Indexing Work?

Direct indexing works by allowing investors to own some or all of the underlying assets within a mutual fund or exchange-traded fund (ETF) directly. Rather than buying a single index fund that holds 40 stocks, for instance, an advisor would purchase individual shares of each stock within the fund to add to a client’s portfolio.

Implementing a direct indexing strategy for your clients often requires more legwork than taking the traditional index fund route. You’ll need to evaluate individual investments for fitness, based on the client’s profile, which can be time-consuming.

There are, however, some potentially significant advantages to applying a direct indexing strategy:

  • Direct indexing can offer more opportunities to reduce what clients might owe in capital gains tax through tax-loss harvesting.
  • A direct indexing strategy can allow for greater customization, as advisors can choose which of the securities in an index to buy to stay aligned with the client’s goals, risk tolerance and values.
  • Direct indexing can reduce the risk of a client becoming overconcentrated in a single asset class or sector since there’s less chance of overlapping investments.
  • Taking a direct indexing approach may result in fewer fees for clients than a traditional active management strategy.

Direct indexing can be adapted to fit a wide range of clients, from those who are in the initial stages of building wealth to already high-net-worth investors. It may be particularly beneficial for investors in higher tax brackets who are interested in offsetting gains from other investments through loss harvesting.

Is it a perfect strategy that’s right for every advisor and their clients? Not necessarily. On the client side, it may require a larger minimum investment while advisors may find themselves spending more time researching and trading individual securities. Direct indexing attempts to match the market, not beat it, may make it less appealing for investors who are seeking higher returns.

Those are just some of the pros and cons to consider when evaluating whether it makes sense to offer direct indexing to your clients.

What Do Direct Indexing Providers Do?

Financial advisors researching direct indexing platforms to get tech solutions for their firm.

It’s entirely possible to implement a direct indexing strategy yourself, but direct indexing providers can eliminate some of the guesswork and save you time. Direct indexing platforms can offer comprehensive tech solutions for registered investment advisors and wealth management firms.

The features advisors have access to vary by platform, but may include:

  • Fractional share trading
  • Modeling and analytics tools
  • Tax loss harvesting
  • Automatic rebalancing
  • Data aggregation
  • Portfolio optimizer or visualizer tools
  • Exclusionary screening tools (for ESG investing)
  • Performance tracking
  • Portfolio transition tools
  • Customized reporting

Some of these tools you may already be familiar with if you’re using financial planning or wealth management software to manage client portfolios. For instance, you may be using a portfolio visualizer to run Monte Carlo simulations or generate other models to allow clients to view potential outcomes for different investment decisions.

The best direct indexing providers also equip advisors with the tools they need to automate and scale as efficiently as possible. API integration, for instance, can make it easier to incorporate direct indexing tools into your existing workflows.

Direct Indexing Strategies

Direct indexing providers may tailor their solutions to certain types of direct indexing strategies. Looking at the platform’s underlying strategy approach is important to ensure that it meets the needs of your business and your clients.

Direct indexing strategies can be:

  • Values-based
  • Rules-based
  • Tax-focused

A values-based approach or personalized is just what it sounds like: direct indexing that takes a client’s personal values or preferences into account. These clients may prefer a portfolio that’s built around ESG (economic, social and governance) investing, socially responsible investing or impact investing.

In that case, you may look for a direct indexing provider that offers tools that are designed for that purpose. Exclusionary screening tools, for example, are designed to help advisors eliminate investments that don’t fit a client’s criteria when applying an ESG approach.

With a rules-based approach, you’re choosing investments for clients based on a set of specific characteristics. For example, if you favor a factoring strategy you might choose stocks based on company size and market capitalization, value or current market momentum.

In that case, it would be to your advantage to work with a direct indexing provider that offers a robust set of tools for tracking and monitoring individual investment performance. Automatic rebalancing would also be an essential tool to have for maintaining clients’ ideal asset allocations at all times.

With a tax-focused approach, the emphasis is on maximizing tax efficiency of client portfolios. The most valuable tech tool a direct indexing provider could offer in that case would be tax-loss harvesting tools that identify opportunities to reduce an investor’s tax liability. If you also offer tax planning as part of your services package, integration with your firm’s tax planning software would also be useful.

Considering which tools or features are most relevant or necessary for your business can help you decide which provider to work with.

Frequently Asked Questions

What Is Direct Indexing?

Direct indexing is a passive investment strategy that involves buying some or all of the securities in an underlying index. For example, advisors may try to match the performance of the S&P 500 in their clients’ portfolios. Using direct indexing can allow for a greater degree of customization in investment portfolios while offering increased tax efficiency when investments are held in a separately managed account.

How Much Do Direct Indexing Providers Charge?

Direct indexing providers can determine how much to charge RIAs and wealth advisors to leverage their platforms and the costs can vary widely. What may be more important to consider than the cost is the expected return on your investment. You may measure that in the number of new clients you’re able to attract to your business or an increase in annual revenues to decide whether incorporating direct indexing tools into your business is worth it.

Who Is the Best Direct Indexing Provider?

Determining the best provider for direct indexing is subjective, as advisors may have different opinions about which platforms offer the most value. When comparing direct indexing platforms, it’s important to look at the entire package in terms of the features you’ll have access to, the fees you might pay and the level of support and guidance the provider offers to help you and your staff make the most of the tools you’ll be using.

Bottom Line

Financial advisors trying a free demo for a direct indexing provider.

If you’re considering offering direct indexing to your clients or you’re already doing so, working with a good tech platform is key. As you shop around for a platform, look for ones that offer a free demo or trial period, so you have an opportunity to try before you buy.

Tips for Growing Your Advisory Business

  • Getting active on social media and building out a professional website for your firm are two proven ways to increase your visibility. Using an online lead generation tool can also help you connect with clients. SmartAsset AMP (Advisor Marketing Platform) is our holistic marketing service that financial advisors can use for client lead generation and automated marketing. Sign up for a free demo to explore how SmartAsset AMP can help you expand your practice’s marketing operation. Get started today.
  • Building out an RIA tech stack can take time as you may need to test different tools to find ones that are most compatible with the way your business operates. Some of the tools you may need to add if you haven’t done so already include customer relationship management (CRM) software, customer communication management (CCM) software, financial planning software and compliance software. That last one is particularly important as registered investment advisors are required to adhere to specific regulatory rules.

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