Executive summary:
- Most mutual funds or ETFs can't solve certain issues that your high-net-worth clients may face today
- Direct Indexing can help investors with tax management, diversifying concentrated positions or imposing restrictions for a variety of reasons.
- Direct Indexing may help solve investment challenges that requires personalization and tax management
Anyone who came of age in the 1980s or 1990s knows that David Letterman was "must-see" late-night television viewing. His show was a staple for many of our generation. While today the thought of staying up to midnight to watch a TV show is unfathomable, back then I didn't think twice. Of course, the highlight of the show was the Top 10 list when Letterman would read out the usually silly or ridiculous top 10 signs, items or issues on some bizarre topic and the audience would laugh.
So, when I began to write this blog about the main reasons for incorporating Direct Indexing into your client's investment portfolio, I thought I would take a page out of Letterman's book. While my list certainly won't be as funny, nor as long, it might be interesting and maybe just a bit educational.
Let's start by quickly addressing mutual funds and Exchange-Traded Funds (ETFs). These investment vehicles have served investors well over the years, but they can't solve certain issues that many high-net-worth investors face today. Fortunately, there are other options, such as Direct Indexing, that are available when mutual funds and ETFs aren't able to meet the needs of the individual investor. So with that being said…
The top five reasons you should consider Direct Indexing for an investment portfolio are:
Drumroll please…
#1: Tax management
One of the most common issues for investors is managing the tax liability associated with their investment portfolio. Recent market volatility, along with potential changes coming out of Washington, DC, have led many investors to think more about the tax implications of their investments than they have in the past.
Using a direct indexing strategy can potentially reduce the tax burden of a portfolio and improve after-tax outcomes. Unlike a mutual fund, where the investor cannot take advantage of the individual losses on the stocks in the fund, with direct indexing, the investor owns a basket of individual securities, each with their own cost basis. This allows the investor to sell the stocks that are down and replace them with similar names. The losses taken from the stocks that were sold can be used to offset capital gains now or a taxable event in the future, such as the sale of a business, property or stocks and bonds.
#2: Values-based exclusions
Many clients may want to express a preference. They may want to embrace environmental, social and governance (ESG) criteria or socially responsible investing (SRI). Or their need could be as simple as an exclusionary restriction of a single security. Direct Indexing allows investors to their values on their terms. With DI, investors can simply choose the index they wish to replicate and exclude the securities or sectors that do not align with their values. In contrast, with an ESG/SRI-focused mutual fund, the portfolio managers decide which companies to invest in.
#3: Optimal portfolio transition planning
Transitioning to a target portfolio is not as easy as simply selling legacy holdings and buying new securities—especially when taxes are a consideration. An immediate transition, such as selling all legacy holdings while buying a new portfolio, can often leave an investor saddled with heavy tax liabilities and worse off on an after-tax basis. By designing a transition plan using direct indexing, investors can move their existing holdings directly into to the new portfolio, receive a result similar to the index, while dealing with their tax liabilities over a set number of years or with a specific tax budget in mind. This way an investor can have a better after-tax outcome over the course of the transition.
#4: Diversifying concentrated stock positions
More than ever, executives or long-term employees are being compensated in company equity—stock options or grants—and are looking at options to diversify their portfolio. Often these positions will have a low-cost basis, making them hard to get out of without incurring a substantial tax hit. Over time, they represent concentrated holdings based on the size of the overall portfolio. Direct Indexing can provide options to diversify the investor's portfolio. By taking losses in a Direct Indexing portfolio and using those losses to offset gains from the sale of shares from the concentrated position, the investor can more tax efficiently reduce their exposure to the concentrated position and possibly improve the overall risk and after-tax return of the portfolio.
#5: Restricting stock and sector positions
Closely related to Reason #2, is the fact that many investors tend to invest in industries where they work. While they may be familiar with the companies within their sector, this can lead to issues with diversification or even single-stock risk. If an investor who works in the tech industry tends to invest only in tech companies, they are setting themselves up for a potential problem when the sector moves out of favor. By implementing a DI strategy, the investor can choose to replicate an index and simply exclude the sector where they are employed and have an overabundance of exposure.
In summary, this top five list certainly isn't as funny as Letterman's, but if you or your clients are facing investment challenges that require personalization and tax management, Direct Indexing might be an interesting option to explore.