You’ve heard of direct indexing, and some supporters have gone so far as to say it’s the future of investing. While it’s largely accepted that personalization is critical, what does direct indexing really mean, and how can a smaller practice achieve it at scale?

It’s no secret that over the last decade, passive investing has grown exponentially. At the same time, investors have demanded the ability to express their personal values through their investments, and tax management has become an important component of demonstrating value in portfolio management. Direct indexing may be a way of “having your cake and eating it too” when it comes to providing investors with the index exposure they want without having to sacrifice other priorities. 

Direct Indexing allows financial advisors to take a passive strategy and customize it for end-investors. While it’s not a new strategy, the need for advisors to continue to show value amid fee compression and the rise of the robos has made it more relevant than ever. Direct Indexing has been gaining popularity, and financial advisors who do not have a strategy for it may be missing out to the competition. Providers of direct indexing technology have also been gaining attention as large asset managers continue to acquire these companies and incorporate them into their advisory tools. 

The good news is that while this strategy was once limited to large asset managers or through high fee SMAs, emerging technology, fractional share availability, and the elimination of trading costs in the form of commissions means direct indexing has become more accessible to portfolios of all sizes.

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Ready to take the first step? Here are four things you may not know if you are starting to explore direct indexing. 

1. You’re Not Just Replicating An Index.
   Direct indexing means you own stocks directly, which is positive as you can customize the index if that’s what clients want and need. This allows an advisor to optimize for taxes by harvesting losses, customizing for ESG exposure, or other factors. Direct indexing allows you to sell or avoid stocks that don’t align with a client’s approach to ethics or investing interests or work with a model portfolio to accommodate customizations. Make sure that clients know that if your version of the index starts to differ significantly from the original index in terms of sector weightings and other attributes, the performance will differ as well. There could also be fees beyond investing directly in an ETF.
2. Complexity Can Be A Limiting Factor.
   While the potential upside for direct indexing solutions is very real, so too are the challenges for investment professionals who want to offer these personalized strategies. It may be difficult to replicate a highly liquid index. Keeping track of all the moving data points on an index with hundreds of separate securities can be an operational nightmare. Working to mitigate tax liability involves risk, and is best done with the help of a tax professional.
3. It’s Not For Everybody.
   Direct indexing really only makes sense for people who have a considerable amount of investable assets in a taxable account. Applying this strategy in tax-deferred accounts such as a 401(k) or IRA, the potential tax-harvesting benefits of direct indexing will not benefit the client. It also only makes sense for clients who seek customization they couldn’t otherwise access through a portfolio of funds or individual securities.
4. Technology Can Help.
   While there are certainly benefits, executing on Direct Indexing can become a laborious manual effort, especially for smaller advisory practices. The key is how to leverage the right technology to deliver it at scale across all of your clients’ portfolios. Different providers offer different levels of customization, so ensuring you work with one that is cost-effective and allows you to tailor across client needs is key. 

Looking For A Solution?

Fortunately, technology that captures investor preferences and allows you to act on those preferences such as TIFIN Personality offers a scalable and cost-effective way to deliver personalized, risk-adjusted portfolio solutions to your clients. TIFIN Personality is not direct indexing technology, rather a platform that empowers advisors toward hyper-personalization. We employ thematic investments to help advisors tilt a portfolio into alignment with client goals, values, viewpoints, and interests to create complete harmony between an individual and their finances.