As more investors — especially younger, high-income professionals — want to hold stocks that they deem socially responsible, they want a customized portfolio that meets their specifications. Through direct indexing, financial advisers can create a basket of individual stocks designed to hew closely to an established index such as the S&P 500 SPX.
In addition to accommodating clients who want to align their investments with their personal values, there are two other reasons that advisers may offer direct indexing. First, high-net-worth individuals may worry about the tax hit if they sell appreciated stocks. The portfolio optimizer technology that advisers use for direct indexing offers guidance on harvesting tax losses to offset capital gains.
“We’ve had clients who have inherited a portfolio with stocks that produce huge long-term gains,” said Ken Nuttall, a certified financial planner in West Grove, Pa. “Direct indexing can help with tax management of inherited assets.”
Direct indexing also appeals to clients who have loaded up on their company’s stock. Eager to diversify their holdings, they do not want to own other stocks in their industry. So they ask their adviser to track an index like the S&P 500 but without stocks from their employer’s sector.
One downside is that the custom portfolio becomes too independent. “There is a risk the direct indexing portfolio will deviate from the [benchmark] index,” said Noah Damsky, a Los Angeles-based adviser. “The client may be looking to create a tracking error to the upside. But it can lead to a tracking error on the downside.”
For many investors, the benefits outweigh that risk. So as long as advisers purchase software that swaps out stocks to advance a client’s goals, tailoring portfolios can gain traction.
“You’ll see more growth in direct indexing in the next year or two,” Nuttall said. “Advisers are using it more and appreciating it more.” The potential for a capital-gains tax increase in the near future adds to the allure of direct indexing. Advisers use the term “tax alpha” to describe the process of leveraging tax-saving moves to boost after-tax returns.
“Our focus is affluent clients who want us to not just mirror an index but to add tax alpha,” said Mike Silane, an adviser in Irvine, Calif. “This is important today, but will be even more important as taxes are likely to rise to pay for today’s stimulus and wealthier clients are likely to feel this most.”