From Smartleaf's Knowledge Center: Direct Indexing

We share an extract from our Knowledge Center. Is managing direct indexes a lot harder than managing ETFs? How do you implement direct indexes? Why are direct indexes more tax efficient than ETFs and funds? What type of firms adopt direct indexes? and more.

Introducing Smartleaf’s new Knowledge Center. It’s a resource that seeks to answer questions on topics important to the industry and your business. Here, we share an extract from the direct index section. For more, visit our full Knowledge Center.

Implementation and Management

It depends. In a well-implemented program, managing direct indexes should be no more complicated than managing an ETF. Direct indexes have more moving parts than an ETF, but almost everything that might make working with a direct indexing challenging can be automated. 

However, some common approaches to implementing direct indexes make managing them more difficult than necessary.

Done right, direct indexes can be as easy to work with as ETFs. However, some common approaches to implementing direct indexes are inefficient. 

Having investor-facing advisors manage direct indexes does not work at scale. Managing taxes and customization — while controlling drift and risk — is complex, and most advisors don’t do it efficiently or well, even with automation tools (worse, it’s a bad use of their time).  

A better – but still suboptimal – approach to implementing direct indexes is to use separately managed accounts (SMAs), meaning you hand just the direct index portion of the account to an internal or external specialist manager. Though common, this approach has two shortcomings: 

(1) SMAs are not optimal for tax and risk.

(2) Working with SMAs is time consuming and therefore expensive. 

The way to avoid these shortcomings is to move from direct index SMAs to unified managed accounts (UMAs) with direct index cores. The idea is similar, but you let whoever is managing the direct index manage the entire portfolio. This keeps ordinary tasks simple — you just let the (internal or external) UMA manager take care of it. In this way, managing direct indexes literally becomes as easy as managing ETFs. Embracing direct indexes needn’t make your operations more complex — it can even make your operations simpler.

Once portfolio rebalancing is delegated, there are no longer barriers to investor-facing advisors offering customization and tax management to every investor. This means: 

• • Every account can have ESG or religious screens.
  • Every account can have risk customization (e.g. if you work for Exxon, eliminate energy stocks from the portfolio).
  • Every account can have tax-smart transitioning, year-round loss harvesting and risk-compensating gains deferral. 

Delegating the day-to-day management of the portfolio – whether to an internal or external group – does come with one cost. It’s incompatible with old-style value propositions based on trade-by-trade conversations with clients, but for most firms, this is a plus. It replaces the unreliable quest for market-beating performance with solid, customized, low-cost, tax efficient investing, which becomes a backdrop for the advisor's main role — acting as the investor’s financial coach and guide.

Tax Implications

Direct indexes are more tax efficient than ETFs because they are better at tax loss harvesting, gains deferral and (in the case where you have legacy holdings of appreciated individual securities) tax-sensitive transition. More specifically:

• • Tax loss harvesting: If you purchase an ETF and its underlying index goes up in value, you can’t do any loss harvesting. But even though the index went up, it’s likely that some of the individual shares went down. With a direct index, you can sell those individual losers.
  • Gains deferral: If you sell an ETF, you’re effectively selling every share of the underlying index pro rata. With a direct index, you can selectively avoid selling the top gainers. 
  • Transition: Imagine you want to transition a legacy equity portfolio into an index. If you invest in an ETF, you’ll have to start by liquidating your existing holdings. With a direct index, you can incorporate some of your current holdings into your direct index portfolio. The only trades you need to make are those required to reduce concentrations and fill in missing sectors.

The correct answer is “it depends”, but we think a reasonable estimate is that direct indexes add around 1% per year in higher after-tax returns. This is only an estimate, and your results may be very different, depending on:

• • your tax rates (the higher your tax bracket, they larger your tax savings).
  • whether you can use realized losses to offset gains from elsewhere in your portfolio.
  • your legacy holdings (direct indexes are especially valuable if you are transitioning from a legacy portfolio of appreciated individual securities). 
  • your asset class mix (the more volatile the asset class, the more opportunity for loss harvesting and gains deferral).
  • market movements (less tax savings in flat markets, more in down markets from tax loss harvesting, more in up markets from gains deferral)

To illustrate what’s possible, we did a five-year backtest of a sector-rotation strategy implemented with ETFs vs direct indexes. The results: the direct indexes added 1.93% per year in tax alpha:

We also did a simulation of the loss harvesting potential of direct indexes compared to ETFs and found that direct indexes supported 3 to 5 times the loss harvesting. See here for details. 

Have more questions in mind? Visit the full Knowledge Center page, or reach out to us with a question or suggestion using the form below.