Direct indexing has become a bit of a buzzword in the financial press. It sounds interesting, but do you really understand the power and potential applications of direct indexing for your clients? How can you differentiate your practice and gain value with this investment solution when used within a unified managed account (UMA)?
While the decision to use a direct index is important, where you choose to house the solution is just as important. Most advisers nowadays use direct indexes as a standalone separate account (SMA). Worse yet, some use software to generate trade ideas for the adviser. In fact, according to the 2022 Cerulli Direct Indexing leaderboard, less than 2 percent of those $208 billion in assets reported are held within a UMA. Yet, it is within the UMA structure where the true power of direct indexing is unlocked.
Let’s start with the what, then get to the why of direct indexing. Index investing has been popular for a number of years. The intent of index investing, also known as passive investments, has been to achieve a “market return.” For highly efficient asset classes such as large cap, fund managers rarely beat the benchmark. In fact, during 2021, according to Morningstar, only 26 percent of fund managers beat their benchmark. So, if excess returns are very difficult to get through active investing, why pay extra for it? This has traditionally been implemented via index mutual funds or ETFs that track an index like the S&P 500.
Direct indexing involves owning all or a representative amount of the securities in an index directly versus through a mutual fund or an ETF. Direct indexing offers your clients more control over their portfolio while still receiving the benefits of tracking an index. A study done by industry expert Cerulli Associates in August of 2021 showed that the projected five-year growth rate of accounts using direct indexing was 12.4 percent. This exceeds growth rates for ETFs (11.3 percent), SMA programs (9.4 percent) and mutual funds (3.3 percent).
Innovations in digital investing platforms fueled by technology have made direct indexing a more accessible and practical solution for investors seeking more customization in their portfolio. Direct indexing opens new avenues in investing for your clients. It also offers a wealth of opportunities for those advisers who can master how they construct direct indexes for their clients. Perhaps of equal or greater importance is how you are solving real-life situations for clients with direct indexing.
Specifically, consider the problems direct indexing solves when used in a UMA, including:
- Cost savings from delivering tax alpha
- Core satellite allocations can tilt a portfolio in a direction directly aligned with your client’s goals
- Defend fee compression and use it in your favor
- Deliver a level of personalization that your competitors cannot
- Tout your ability to design customized direct indexes to meet portfolio needs
- Additional revenue stream
- Decrease capital gains for breakaway legacy assets
Direct indexing is here as a mainstream investment option for high-net-worth clients. Your competitors will likely be offering direct indexing. You should be too, but you should be offering a better version of direct indexing, as a highly differentiated solution with a UMA.
Using a UMA in conjunction with direct indexing offers a comprehensive and potentially beneficial solution. Not only can you provide direct indexing, you can also do this in conjunction with managing all of their assets in one place. This promotes tax-efficiency and makes asset allocation decisions easier.
This article was excerpted from a report by Adhesion Wealth, a wholly owned subsidiary of AssetMark. Read the full report here.