Staying ahead of the game with direct indexing in financial advisory

Hockey superstar Wayne Gretzky once said his secret to success was that he skates 'to where the puck is going to be, not where it has been.' This adage works not only for sports but for running an investment practice as well.

One of the advantages of being in the financial services industry for almost 30 years is that I have witnessed a lot of innovation. When I entered the business in the early 1990s, financial advisors were mostly building their own portfolios by picking individual stocks and bonds and charging a large commission (by today's standards). Mutual funds were mostly sold as "A" shares with an upfront charge as high as 5.75%. The 1990s introduced the concept of fee-based portfolios and separately managed accounts to the mass affluent. This period also saw the launch of Exchange Traded Funds (ETFs) and index funds, spurring the popularity of passive investing among individual investors.

Looking back, I believe the financial advisors who were most willing to adapt to changing times were generally more able to set themselves apart from the crowd and experienced a higher rate of success. I can think of numerous examples over the years. The bear markets of 2000-2003 and 2008 were a very difficult time for commission-based advisors as clients were hesitant to act in the volatile markets. Over the last decade, financial advisors who neglected to add low-cost passive investments to a portion of their client's portfolios may have had to respond to concerns about cost and performance.

If you want to emulate the Great One (Gretzky's nickname) you need to think about where the puck is heading next and how you can make sure you are prepared.

A trend to keep your eye on is the emergence of direct indexing.

The rise of direct indexing

Direct Indexing has seen tremendous growth, accounting for $535.1 billion in assets under management by the end of Q3 2023 as illustrated in the chart below. We believe direct indexing is a game-changer, allowing your clients to directly own individual stocks and harvest their losses, bypassing the traditional approach of investing in funds or ETFs. With direct indexing, you have the flexibility to construct a personalized portfolio tailored to your clients' specific preferences and goals. Emerging as the leading choice among Separately Managed Account (SMA) options, this approach now surpasses other equity portfolios in sales.

MMI/Cerulli Top Objectives in SMAs

1 Assets include dual-contract SMAs.

Sources: FUSE, Money Management Institute, Cerulli Associates. Used with permission

Moreover, direct indexing is projected to grow 12.3% annually.2 Reaching a total asset value of $825 billion by the close of 2026 according to Cerulli Associates, Notably, it allows advisors to exercise control over the timing and how clients realize capital gains, significantly enhancing the tax efficiency potential of their portfolios.

What does that mean for financial advisors and the future of your business?

As the data suggests, there may be value in skating to where the puck is headed. Remember when the coffee shop used to call out your order? Now they call out your name rather than an Americano with milk. That's because personalization has become the trend in specialty coffee shops and numerous other retail sectors. Financial services are no different. There has been a clear demand from investors for a more personalized client experience and an investment portfolio that reflects their unique goals, circumstances, and preferences.

Adopting direct indexing may help showcase the value you provide to clients and also potentially fuel the growth of your business this year. Our recent survey of more than two hundred of our own advisor clients revealed a significant shift in their concerns about the upcoming year. Unlike the previous year dominated by market volatility and recession fears, 63% of respondents now express a primary focus on 'Growing my business.'

This shift marks a return to growth, emphasizing the importance of expanding your business. We believe there is substantial untapped potential within your existing client base. Through our work with advisors, we've pinpointed five key areas where direct indexing can markedly benefit investors:

  • Effectively managing concentrated stock positions
  • Strategically preparing for taxable events
  • Smoothly transitioning unmanaged accounts
  • Personalizing investments to individual preferences
  • Implementing year-round tax loss harvesting

Consider how these aspects align with your own clients' situations. We offer resources to help you and your clients understand and integrate the advantages of direct indexing into your practice. To assist with client inquiries, we've developed an investor-friendly guide for you to leverage - Unleashing the Power of Direct Indexing. Alternatively, feel free to reach out to us directly. Direct indexing becomes more manageable when you seek assistance, so don't hesitate to ask.

Our overarching aim is to support advisors in building more valuable businesses. If you're committed to substantial business growth this year, we stand ready to assist you in achieving your goals.

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