Editor's Note: This is the second installment in a three-part series on direct indexing.

Many registered investment advisors are not proactively offering direct indexing to clients, but it could be a potential new source of revenue and may be an incentive when trying to attract advisor recruits.

Direct indexing gives clients broad exposure to an asset class, such as large-capitalized equities. But rather than buy a mutual fund or exchange-traded fund, investors own the individual stocks that comprise an index. The customization comes in when advisors tweak which index components they buy — or don't buy — and in what proportions.

Basic Understanding

RIA firms "generally have some basic understanding" of direct indexing "but aren't doing a whole lot of it," according to Scott Kubie, senior investment strategist at Carson Group.

Sixty percent of RIAs surveyed by Broadridge Financial Services in September said they are familiar with direct indexing. That's higher than the percentage of advisors surveyed from wirehouses (53%), independent broker-dealers (41%) and regional broker-dealers (40%).

In terms of the use of direct indexing, only 12% of RIAs surveyed by Broadridge said they use it compared with 18% of wirehouse advisors. The RIAs use matches that of advisors from independent broker-dealers (14%) and is slightly higher than advisors from regional broker-dealers (12%).

"The absolute biggest demand that we see for it is portfolios with embedded gains that want to have a better level of risk management on those accounts than they're currently getting," according to Carson Group's Cubie.

Direct indexing requires advisors to decide the securities to include in the portfolio, the screens — such as using environmental, social and governance factors — to apply, the type of index to try to mimic and how quickly to transition the portfolio closer to the index, Kubie said.

"Those are some big decisions that occur up front, but then the ongoing work is really fairly automated," he said.

Direct indexing is mostly used by high-net-worth clients because of their desire for customization and their taxable accounts are "big enough" to make the strategy "worthwhile," according to Kubie.

Advisors "are generally willing to do some more work in order to get the types of accounts that are going to benefit from direct indexing," he said.

Reverse Engineering

Direct indexing is an opportunity to charge higher fees and could be used as a recruitment tool, according to Barrett Ayers, president at Adhesion Wealth, a Charlotte, North Carolina-based company that provides technology solutions to RIA firms. Adhesion, itself an RIA firm, is a subsidiary of Vestmark.

Direct indexing can be "a whole new revenue stream for advisors if they really understand and start to think about their operational plan to deploy it," according to Ayers.

"Imagine managing a portfolio that was tax-neutral at the end of the year and had their own customized screening capabilities on it. Absolutely that demands a higher fee," Ayers said.

"Switching out a passive index-based mutual fund and moving to something that was far more affordable with a direct index and maybe saving your client five to ten basis points. Absolutely the advisor should think about increasing their fees," he added.

Having direct indexing capabilities can help attract advisors who have access to that strategy in their current firms, according to Ayers.

"Advisors who are thinking about recruiting and bringing on new advisors, those roll-up firms or firms that want to think about M&A, this is an incredibly important part of their strategic roadmap," he said.

"Imagine a breakaway advisor who you want to recruit over to your firm. All these holdings that were managed over at the wirehouse could be absorbed into a direct index," he added.

Advisors must be clear about how they are going to deploy direct indexing if they decide to offer it to clients, according to Ayers.

"Advisors need to take a step back and reverse engineer exactly what it is that they're trying to do," he said.

Building a portfolio "that blends active and passive together in a core satellite strategy" is the most common use case for direct indexing, according to Ayers.

"Advisors are looking to blend active and passive, and it no longer makes sense to do that with a large S&P 500 mutual fund or one ETF in the middle of a larger portfolio," he said.

Advisors need to consider "how they are going to manage five separate sleeves: one of them is now this direct index but the other four are going to be things like All Cap Core, International, Large Cap Growth and some other asset class," according to Ayers.

Advisors should be asking themselves: "How am I going to manage a client who has unique allocations to those five components, one of which is now my direct index?" Ayers said. "That is the operational hurdle that most people should be focusing on. They now have tools all over the place to get the direct index — how are they going to manage that module inside of a larger portfolio allocation?"

Offerings

Carson partners with Parametric Portfolio Associates to offer direct indexing — tracking 23 equity indexes — to advisors on its network, according to Kubie.

Parametric can include appreciated securities in the portfolio to minimize initial capital gains, according to Kubie. Clients can further customize the portfolio by screening based on ESG or religious concerns and can limit certain securities or industries based on the industry they work in or other investments they own, he said.

Adhesion offers direct indexing for advisors, who are able to provide their clients with real-time risk mitigation tools and the ability to tax-loss harvest individual positions, according to information on its website.

Charles Schwab has been piloting a direct indexing program, Schwab Personalized Indexing, for individuals with at least $100,000 in investable assets. It will be made available in early 2022, according to Schwab Asset Management chief investment officer Omar Aguilar.

"The innovation and technology that's coming with direct indexing allows you not only to invest in an index but allows you to be more transparent, to have more flexibility and the ability to create personalization," Aguilar said last month at Schwab's Impact 2021 conference.

Tomorrow: Advisors at B-Ds Lag Wirehouses, RIA Firms in Direct Indexing

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