As clients increasingly demand bespoke solutions that reflect their unique financial goals, tax situations, and personal values, traditional investment vehicles such as mutual funds and exchange-traded funds (ETFs) are often found lacking in flexibility. Direct indexing is an investment approach that aims to provide the flexibility, precision, and customization advisors are finding best meets client-specific requirements.
Direct indexing, implemented through separately managed accounts (SMAs), allows clients to own the individual securities that are constituents of a chosen benchmark index. This ownership structure facilitates a high level of customization, enabling advisors to optimize portfolios for tax efficiency, tailor exposure to specific asset pricing factors, and align investments with personal values. In this brief article we’ll explore some of the ways direct indexing can empower advisors to deliver uniquely tailored investment.
Unlock the potential for after-tax alpha
One of the most compelling potential benefits of direct indexing is its ability to optimize portfolios for tax efficiency. Tax-loss harvesting—a process by which securities which have declined in value are sold to offset gains elsewhere in the portfolio—becomes a powerful tool when managing individual securities. Unlike ETFs or mutual funds, where the client has limited control over tax events, direct indexing allows for ongoing tax management tailored to the client’s unique tax circumstances. And because direct indexing strategies typically hold more positions than a typical actively managed SMA, the opportunities for harvesting losses are increased.
Ongoing tax optimization
In traditional investment vehicles, capital gains distributions are often unpredictable and can result in unexpected tax liabilities. With direct indexing, the portfolio manager can systematically monitor the portfolio throughout the year, capturing tax losses whenever opportunities arise. These losses can be used to offset gains either in the same portfolio or in an entirely different account or asset.
Over time, these incremental tax savings compound, enhancing after-tax returns. This strategy is particularly valuable for high-net-worth individuals who face significant capital gains taxes or for clients looking to offset gains from the sale of a business or real estate.
Deferring capital gains
Direct indexing also allows for strategic deferral of capital gains. By retaining high-cost basis securities and selectively harvesting losses, advisors can delay realizing gains until it aligns with a client’s broader financial strategy, such as retirement or estate planning.
Manage risk with precision
For many clients, concentrated risk—whether it’s due to industry or sector exposure, employer stock, or personal preferences—can be a significant concern. Direct indexing addresses this issue by allowing advisors to customize the portfolio’s composition, including the restriction of specific securities or sectors that don’t align with the client’s goals or circumstances.
A client who works in the technology industry, for example, may already have significant exposure to tech stocks through their compensation or retirement plan. To mitigate concentration risk, an advisor can constrain or eliminate technology holdings from the client’s direct indexing portfolio, ensuring a more diversified allocation. The portfolio manager will optimize a portfolio that excludes these restricted holdings.
This level of control enables advisors to craft portfolios that are not only diversified but also tailored to manage specific risks unique to each client.
Capture potential outperformance
Factor-based investing—an approach that emphasizes well-known characteristics such as value, quality, momentum, or low volatility—has long been a staple of institutional portfolio management. Direct indexing brings this sophisticated strategy to individual clients, enabling advisors to tilt portfolios toward specific factors that align with the client’s investment philosophy and objectives.
Building a factor-enhanced portfolio
For instance, a client who seeks to outperform the benchmark through a prioritization of long-term growth might benefit from a portfolio tilted toward quality and momentum factors. Conversely, a client seeking to preserve wealth during volatile markets might prefer a low-volatility tilt.
Direct indexing allows advisors to implement these factor exposures in a client portfolio in a diversified manner, ensuring that the portfolio remains aligned with the client’s risk tolerance and financial goals. By customizing factor tilts, advisors can enhance the portfolio’s potential for risk-adjusted outperformance, a key value proposition for clients seeking to optimize their investments.
Align investments with values
There are certain clients who increasingly seek to align their portfolios with their personal values, whether those values are driven by environmental, social, or governance (ESG) concerns, faith-based principles, or other ethical considerations. Direct indexing can provide the flexibility needed to incorporate these preferences without compromising financial goals.
Implementing ESG preferences
For example, a client passionate about environmental sustainability might request a portfolio that excludes fossil fuel companies while overweighting renewable energy stocks. Another client may wish to avoid companies involved in tobacco, alcohol, or gambling, reflecting their personal or religious values. Still other clients may seek to implement a more thematic overlay, such as one that focuses on wellness, conservation, or community.
Direct indexing makes it possible to integrate these preferences seamlessly, creating a portfolio that resonates with the client’s beliefs. This alignment fosters a deeper connection between the client and their investments, helping to enhance satisfaction and loyalty.
Customize portfolios with direct indexing for potential client growth
Direct indexing is redefining the way advisors construct client portfolios, offering customization and control. By leveraging its capabilities—such as tax management, security and sector restrictions, factor tilts, and values alignment—advisors can deliver highly personalized solutions that resonate with clients’ financial and ethical priorities.
"Proposing solutions customized to your needs and goals is considered extremely important by 71% of affluent households."
Cerulli Report: U.S. High-Net-Worth and Ultra-High-Net-Worth Markets 2024
As the demand for personalization continues to grow, direct indexing represents a powerful tool for advisors looking to differentiate their practice and deepen client relationships.
By: Hunter Willis, CFA®, QRG Portfolio Manager, and Brandon Thomas, Managing Principal, QRG
For more information about Envestnet's QPs, which are managed by the company's quantitative asset management unit, QRG Capital Management, Inc., please visit: https://www.envestnet.com/qrg/.
