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Portfolio > Portfolio Construction

Why RIAs Can’t Ignore Direct Indexing in 2023

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What You Need to Know

  • The use of direct indexing helped advisors achieve meaningful tax savings for clients during a volatile 2022.
  • More advisors are expected to use direct indexing and model portfolios to deliver customized strategies to clients.
  • Researchers project that direct indexing will grow at a faster rate than ETFs, mutual funds and separate accounts.

As of the end of the third quarter, the year-to-date tax savings delivered by advisors engaging in tax-loss harvesting for clients in model portfolios was an impressive 2.99%, while dating back to 2020, the annualized tax savings was 2.82%.

This is according to new data shared by 55ip, a financial technology platform designed to help registered investment advisors deliver tax-smart investment management at scale. The firm specializes in supporting advisors as they utilize direct indexing approaches within their model portfolios, with the linked goals of allowing greater portfolio personalization and tax efficiency.

Paul Gamble, CEO of 55ip, says the savings data demonstrates the value of engaging in loss harvesting within client portfolios throughout the year rather than waiting for the year’s end. By harvesting losses regularly, advisors are able to exploit what may be shorter-term dips in security prices.

When an advisor waits for the end of the year to look for loss harvesting opportunities, Gamble explains, prices of key stocks (or the entire portfolio) may have rebounded, leaving fewer and smaller losses to offset capital gains.

“Volatile markets can be emotionally and financially challenging for investors,” Gamble says. “However, our data indicates they can also present potential opportunities for meaningful benefits from a tax perspective, especially when advisors take a strategic approach throughout the year.”

The Rise of Model Portfolios and Direct Indexing

According to Gamble, the significant amount of tax savings realized by advisors helps to explain why the use of model portfolios and direct indexing is among the fastest growing trends in asset and wealth management. Until recently, Gamble suggests, many advisors had concerns about the tax implication of transitioning to a model portfolio approach, but that is changing.

“In today’s environment, advisors can turn to firms like 55ip for automated tax management and portfolio transition capabilities,” Gamble says.

Since January 2021, the firm’s platform has enjoyed a 125% increase in the number of participating advisory firms and a whopping 357% increase in the number of client accounts.

“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.”


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