From sports car to minivan: Direct Indexing can help you give your clients the ride they want
Executive summary:
- Direct indexing strategies can help you customize a portfolio for your clients according to their specific needs
- An investor’s priorities can change as their lives become more complex, just as you may want a sports car in your youth and a minivan as you create a family
- Those priorities could include avoiding a concentrated portfolio, tax management or values-based investing
When I was in high school, I really wanted a car. My loving parents took every situation as an opportunity to teach. They told me that if I wanted a car, I would have to earn it.
Not long into my search I found what I thought (at the time) was the perfect car. A bright red freshly painted 1983 Ford Thunderbird with a V8 engine! It rode low to the ground and was modified with a digital display. I knew I had to have it.
That summer I got a job at a local retail store. Due to the large staff of high school kids looking to earn summer money we were each given only 10-20 hours per week. Based on some quick math I realized that would not enable me to save enough money for a car. I decided to take matters into my own hands and started a lawn-mowing business in our suburban neighborhood just outside Seattle.
To make a long story short, I worked hard all summer at both jobs and sacrificed a lot until I finally had enough to buy my dream car. Through a stroke of luck, it was still available. I’ll never forget the first time driving that beauty – or the lessons that I learned about hard work and entrepreneurship that summer.
Fast forward to today, and I’m a husband and father in my 30’s. I still love cars, but the features that matter most to me have shifted (sorry, dad joke). When I’m driving my kids to their activities or taking my wife on a date I care less about speed and the loudness of the engine, and more about things like comfort, safety, and -- dare I say, gas mileage.
Similarly, as people grow in their careers and build wealth, their financial situation may become more complex. This means that the features they look for in a portfolio might change. A young investor may look for a “flashier” portfolio that has a strong growth component. That’s because their timeline is generally longer and their ability to take risks is usually higher. But as investors age and their lives become more complex, their needs change. Things like tax considerations, asset allocation, and customization become more important. They may even be less concerned with reaching their financial destination quickly, and more concerned about the smoothness of the ride.
This is where Direct Indexing strategies can be useful.
Direct indexing allows investors to directly own a group of securities that represent an index in a Separately Managed Account (SMA). The investor gets the same market exposure as the index but can also choose a customized portfolio to fit their specific goals, needs, or circumstances by excluding certain securities or holding them at a different weighting than the index. This approach not only allows for greater customization but also greater flexibility.Direct indexing is also handy for tax-sensitive investors. The ability to selectively determine when to take a loss or a gain can help the investor manage their tax bill. Losses can be held in the portfolio indefinitely and can either be used to offset gains in another part of their overall portfolio or carried forward to be used in future years if there are no gains elsewhere to offset.
Advisors can use direct indexing to build portfolios that provide index-level returns, optional customization, and tax loss harvesting when used in a non-qualified account. Direct indexing can help:
- If a client has a concentrated stock position that they’d like excluded from future purchases
- If a client has investing preferences that are based on their personal beliefs
- A client who is employed at a publicly traded company with restrictions on buying/selling company stock
- If a client has substantial unrealized gains in a taxable account but is hesitant to change their allocation due to having a low cost basis and is concerned about the impending taxes that would result from realizing those gains.
Interested in a test drive?
A tax transition analysis can be a powerful tool to help your clients understand how to migrate a concentrated or unmanaged portfolio to a customized and diversified investment strategy while managing the related tax burden. Then, just like choosing between manual and automatic transmission, they can choose a timeline transition or a tax-budget transition. If the client has a stronger desire to control the amount of taxes generated each year, then they may want to consider a tax-budget transition; If the client prefers to control the time it takes to transition to the target portfolio but also wants to spread taxes across multiple years, then they may want to consider the timeline approach.
Very few if any people drive the same car for their whole life. While investments strategies should be long term, investors are increasingly asking for solutions that are tailored to their needs.