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Financial Advice

An Inside Look at Direct Indexing

Direct indexing is becoming a key addition to financial advisors’ toolkits.

Commonly referred to as the “great unwrapping,” direct indexing has the potential to be the next disruptive force in asset management. In the same way that the invention of the exchange-traded fund competed for investor dollars with mutual funds, direct indexing could potentially compete with both ETFs and mutual funds in the years ahead.

The burgeoning direct indexing industry is now ripe with offerings, and Morningstar launched a direct indexing offering to serve financial advisors in 2022.

Morningstar Wealth’s “Simple, but Not Easy” podcast recently tackled the evolution of direct indexing, what it can solve for, and the ideal client it ultimately serves. For the episode, titled “An Inside Look at Direct Indexing,” host Jonathan Linstra, managing director, Americas, at Morningstar Investment Management, sat down with Andy Kunzweiler, portfolio manager for Morningstar’s direct indexing offering, and Sheryl Rowling, an editorial director at Morningstar. Below are the key areas they covered.

What Is Direct Indexing?

Direct indexing refers to a separately managed account that tracks an index or a blend of indexes while holding the individual stocks that comprise the index. Said differently, mutual funds and ETFs are wrappers that sit between investors and the stocks they own. Direct indexing removes that wrapper and allows investors to hold the individual stocks that sit inside the index.

Kunzweiler explains it succinctly: “This is not new to the industry, but it is new to a lot of investors and their advisors. … It gives you far greater control of your tax situation as opposed to investing via an ETF or a mutual fund.”

Much like owning a mutual fund or ETF that tracks an index, direct indexes invest and rebalance according to a predetermined methodology. But with direct indexes, an investor can customize the methodology according to their preferences and adjust as circumstances change.

Owning the individual stocks rather than a bundled product gives investors greater control and customization options in addition to far greater command over their unique tax situation.

Put simply, as Linstra says, you can “make the index your own.”

Life Before Direct Indexing

In the past, an investor needed to sell an entire mutual fund or ETF from a taxable account to generate a tax loss—an all-or-nothing proposition. With direct indexing, an investor holds the individual securities, which opens possibilities for deeper tax-loss harvesting at the individual stock level.

According to Kunzweiler, the average “tax drag” on a mutual fund held in a taxable account is around 2% per year. Direct indexing also offers the opportunity to manage taxes on the gains side. Says Kunzweiler, “One of the ways we do that is through tax-sensitive transitions, tax-sensitive withdrawals, basically, looking to incorporate a tax-sensitive approach to every aspect of portfolio management.”

Ideal Client for Direct Indexing

Tax management is likely the most obvious attraction of direct indexing for clients. The ability to harvest losses throughout the year can help remove any surprises when doing year-end tax planning.

A second attraction would be clients who have a unique preference that they would like to express in their portfolio. If a client is a company executive who holds a sizable amount of company stock, they can create a portfolio that excludes that company or the industry the company resides in to remove industry risk from a portfolio.

Rowling covers this point nicely, saying that by using a direct indexing approach, “you can actually come up with a plan to build the portfolio around those concentrated positions as you sell them off gradually, so that you can replicate the index more closely as you’re able to sell pieces in order to diversify the portfolio fully.”

However, like anything in life, direct indexing is not for everyone. A client who has large, embedded capital gains in a taxable account and is not actively adding new dollars to the account would likely not benefit from direct indexing.

Additionally, tax-deferred accounts would likely only make sense for clients who have a specific customization preference, as they will not benefit from tax management.

The Value Proposition of Direct Indexing

Rowling sees direct indexing as “transformational” for advisors. To put a finer point on it, she says, “It can be laborious to do tax-loss harvesting, and it is extremely laborious—even with software—to do capital gains distribution avoidance at the end of the year. If you have direct indexing, your client owns the individual stocks. There is no such thing as a capital gains distribution, and so there is a lot more control over that. It’s set on automatic pilot because direct indexing will take care of doing the ongoing tax-loss harvesting. And at least the advisor is more free to pay attention to other aspects of the client’s needs. … There are a lot of choices out there when looking at direct indexing. And to me, it’s all about the reputation of the company doing the offering.”

Direct indexing is the latest innovation to democratize investing and provide investors with the ability to customize portfolios.

Cerulli Associates projects direct indexing is poised to grow at a faster rate than ETFs, mutual funds, and separate accounts over the next five years and will reach more than $800 billion in assets by 2026.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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