Q&A: How Financial Advisors Can Use Direct Indexing With Clients | Financial advisers
Index funds are a great place to start for many investors. They offer diversification, liquidity and low cost options for quick and easy investing.
But when investors – especially high net worth investors – turn to financial advisers for advice, they often want something a little more personalized than a cookie-cutter index fund. After all, these funds can be inexpensive, but they can’t give investors control over a personalized portfolio of individual stocks.
With direct indexing, investors bypass the index fund envelope by directly buying the individual stocks of the index fund, thereby 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 of the 500 companies in the fund.
Of course, this can create a financial hurdle for many investors. Few people can afford to buy a stock of every company from an index. This made direct indexing an institutional strategy for many years. But now, with the advent of fractional shares – when investors buy a fraction of a stock rather than a whole stock – direct indexing has become more affordable. Financial advisers can use the strategy with their retail clients.
To learn more about direct indexing in today’s markets, we spoke to Michael Blundin, CTO at Vestmark and expert in direct indexing strategies. It explains how financial advisors should approach direct indexing and which clients can benefit the most from the strategy. Here are edited excerpts from this interview.
Why should advisors consider direct indexing for their clients?
Direct indexing offers better tax management than mutual funds and exchange traded funds through direct ownership of individual securities. This not only avoids distributed capital gains, but also proactive tax harvesting of offsetting losses against gains.
Direct indexing also presents a wider opportunity for personalization. Clients can express their personal preferences and opinions in terms of social values, factors such as dividend yield or low volatility, or inclinations such as value or growth, as well as any personal restrictions in terms of industries or individual titles.
For which customers is direct indexing a good solution? Which clients would be best served with traditional index funds?
Historically, this type of product was reserved for institutional and very high net worth clients, but technological and operational advances are increasing the availability of direct index products for 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 choice for these packaged products, and although the investor might lose the ability to express their personal investment preferences for environmental, sustainability and safety factors. governance, or ESG, in the same way as a separately managed custom index account would allow, the total all-in cost of the portfolio could be lower.
What are the main obstacles to direct indexing and how can advisors overcome them?
Our industry strives to provide more sophisticated solutions and make investment products accessible to more people, but technical challenges remain, such as fractional shares or hard-to-reach investment minimums. .
There are also technological and educational challenges in integrating personal ESG preferences and portfolio impact into the dialogue between a financial advisor and a client. Finding the easiest way to communicate and deliver what the investor wants is one of the challenges technologists and advisors are trying to solve.
Advisors should pay attention to the capabilities of the platform. Tax optimization and personalization can be difficult to scale, and understanding the impact of transaction costs in a personalized index portfolio is another challenge for advisors.
But players in our industry are always looking for innovative ways to generate additional revenue to offset transaction costs. From a diversification perspective, an investor needs a portfolio that adapts to more investment strategies than just direct indexation to have a well-distributed asset mix, such as ensuring clients have access to good fixed income strategies.
How can advisors facilitate direct indexing by automating workflows and tax batches?
Automating client data collection and workflows can help advisors create personalized products for each investor without the advisor having to ask many potentially cryptic questions. Technology, including the creation of elegant client portals that allow clients to enter information, communicate and interact virtually with advisors, helps automate this process, making onboarding faster and easier for clients. clients and advisors.
Automation is also essential in several other areas, such as building, managing and rebalancing custom portfolios, as well as collecting, trading, rebalancing and reconciling tax losses.
What else do advisors look for when evaluating investment products for their investors?
For an investment product to be successful, several things are required.
First, the product itself must work from a regulatory standpoint. The technology and platforms underlying the product must make it work effectively at scale.
Additionally, advisors must be able to understand and sell the product and simplify the process. And, at the end of the day, customers have to want it. There must be demand.