Investopedia.com defines direct indexing as “an approach to index investing that involves buying the individual stocks that make up the index, in the same weights as the index.” For example, rather than owning a mutual fund or ETF that tracks the S&P 500, investors can replicate the index, meaning they would own all of the individual 500 stocks that comprise the index. Investors can also sample indexes, which simply means purchasing enough of the index holdings, whereby the investor should receive similar exposures, and returns, as the index. Sampling is often done when replication is not possible or too inefficient, and a great example of how many advisors are looking to direct indexing to slowly offload a large position with a low basis (more on that later).
Direct indexing is consuming a lot more ink recently, and one of the primary reasons might be that the elimination of commissions on equities has made it dramatically less expensive to pursue. And, technology, too, might be a big driver. New software tools open the door for an advisory practice of any size to offer it. Orion’s ASTRO, as an example, is an affordable direct indexing tool that advisors on our Orion Essentials platform at XYPN Invest can seamlessly build into their trading tech. In the recent past, advisors had to look to professionally outsourced options when direct indexing was needed. And a third possible explanation: custodians introducing fractional share purchases have helped to expand the opportunity for direct indexing to relatively smaller accounts where the volume of tickers required and minimum share prices would’ve previously demanded substantially higher assets to accurately sample an index.
With increased interest in direct indexing naturally came an uptick in M&A activity. Fund companies and other large investment companies have looked for a quick entry into the market by acquiring direct indexing providers, such as in these examples:
And don’t forget that other new entries into the market include asset managers like Dimensional Fund Advisors and Avantis, and custodians (Schwab, for example) are now in it, too.
In short, the proliferation of direct indexing gives advisors the chance to help their clients achieve good outcomes in increasingly more unique and customized ways. I’m certainly not forgetting that mutual funds and ETFs are still perfectly viable solutions in most cases. But, direct indexing might appeal to advisors in situations when:
Some of the challenges of direct indexing are specific to the client while others are specific to the advisor.
Client-specific challenges include:
There are also some advisor-specific challenges, including:
Currently, there is no shortage of available direct indexing options to choose from, with the list likely to expand. As an advisor, there are many characteristics to understand before determining the right solution(s).
Using our own trading practices at XYPN Invest as an example, we can accommodate individual securities as needed into our ETF/Mutual Fund models. For situations where low-basis positions require special handling (e.g.: for either eventual charitable giving or to slowly realize gains over multiple tax years), we’ll count them towards the equity portion of the model and reduce all of the other equity purchases. And even in the rare case of a low-basis fund, we can count that towards one specific asset class if that might be a reasonable proxy for one of our model holdings. You can create these same workarounds in your trading practices by thinking through and plotting out the equivalencies.
Coca-Cola (ticker: KO) might not be the perfect proxy for your entire Large Cap allocation, for example, but generally counting towards equity seems quite reasonable. Your portfolio implementation—with an allocation to the legacy KO holding—might be more heavily tilted to US equity or to Large Cap than your target model, but it’s sometimes the right trade-off if the unrealized gains in your KO shares are too much of a burden to offload in one tax year. Making these decisions in coordination with your clients and their tax advisors will prove to be quite valuable in building trust and proving your value.
While direct indexing has recently become a hot topic, it is not a new concept and definitely not a fad to be ignored. It’s sure to become common practice in the majority of service-focused advisory businesses like yours. And the beauty of direct indexing is that it can be highly impactful in very narrow circumstances. It does not require a mass rollout to all clients at once. Interested in learning more about direct indexing and the services XYPN Invest offers you and your clients? Reach out to XYPN Invest to learn more and ask any questions you may have about all things investing.
About the Author
Jeff Snodgrass is the Managing Director of XYPN Invest, which provides turn-key investment management solutions for time-savvy advisors ready to streamline their investment process. Jeff's favorite part about his job is connecting with the advisors XYPN Invest serves and hearing stories of the success and achievements of their clients. When he's not optimizing the XYPN Invest client experience or sharing his vast wealth of Orion knowledge, Jeff steeps himself in music—he's played the piano for 25 years and enjoys listening to live music. He also stays busy being the "best dad ever" to his four young kids.