Why RIAs Can’t Ignore Direct Indexing in 2023

“The number of tax-smart transitions, using tax loss harvesting to automatically move client accounts into model portfolios, has reached record levels in 2022,” Gamble adds. “We believe our growth speaks to the rising demand among advisors seeking tax-smart strategies in portfolios.”

An Emerging Consensus

Over the next five years, direct indexing will grow at a faster rate than ETFs, mutual funds and separate accounts, Cerulli Associates forecasts — and Gamble concurs. In fact, he likens the current state of direct indexing to the state of today’s incredibly popular target date funds some 15 or 20 years ago. Back then, TDFs were a niche, emerging asset class, but today they are far and away the most popular fund type used in qualified retirement plans.

“Anyone with any familiarity with the world of defined contribution plans and TDFs will know just how bullish of a prediction that is,” Gamble says. “The growth opportunity is just incredible.”

As most simply defined, direct indexing is the delivery of customized investment strategies that let investors buy and own individual equities in weights comparable to those that make up a chosen index. The approach can be aligned with the investor’s goals and values across many parameters, Gamble says, such as tax advantage, diversification and investor values — including betting on an ESG strategy.

Complex Tax Considerations

According to Gamble, many clients come to direct indexed model portfolios from traditional portfolio building approaches at their preferred brokerage or active management shop. Many want to improve the diversity of their holdings by getting away from cap-weighted indexes, or they want to pursue some other specific goal that they cannot achieve with mutual funds or ETFs, all while being thoughtful about the tax consequences of the transition.

As an example, a client may hold a highly concentrated basket of S&P 500 stocks that has significantly appreciated in value, meaning the client is carrying very large unrealized capital gains. To get to the new portfolio, they will have to sell some or all of their holdings, resulting in capital gains.

In the past, Gamble explains, getting this client’s position unwound and then reinvested in a tax efficient way was a big logistical challenge. While certainly feasible on a client-by-client basis, creating such transition plans at scale was next to impossible for advisory firms lacking access to powerful computing technology. Today, with the growth of platforms like 55ip and its competitors, providers are filling that gap.

“Today’s technology is able to automate those custom transitions for investors,” Gamble explains. “We can customize and diversify around the stocks the advisors give us. They provide us with capital gains budgets or risk targets, and we manage the transition to the customized portfolios.”