Financial advisors can ignore these 2 things when choosing a direct indexing provider


By now, you have probably heard all about direct indexing. You have read how technology has brought a strategy that was once out of reach for all but the wealthiest investors and institutions to the masses. You have read about the arms race among the largest investment managers vying to compete in the space. 

Andy Kunzweiler Morningstar Wealth
Andy Kunzweiler, direct indexing portfolio manager at Morningstar Wealth

Matthew Gilson

And now you would like to offer direct indexing to your clients. You see the value of aligning your clients’ portfolios with their unique investment, tax and risk objectives. But without the resources of a big firm, you need a provider.

There are a lot of direct indexing services out there that will tell you what to look for when seeking out their services. As a practitioner who has managed direct indexing portfolios for the last decade myself, here are two things that I believe don’t matter.

Tax alpha math
Tax alpha is the main draw of direct indexing. (Personalization is important and I’ll touch on it next, but while not everyone is interested in personalizing their investments, everyone is interested in paying less in taxes.)

Over the years, I’ve become familiar with what the academic literature presents as tax alpha, and while I am not here to say that you should not consider tax alpha in your evaluation of a direct indexing provider, some of the numbers out there are shockingly high. Tax alpha of 3% to 4% per year? Sign me up! 

Here are three reasons you should look at any tax alpha claim with a healthy dose of skepticism.

First, cherry-picking can, and sometimes does, occur. Time periods with declining markets or heightened volatility can lead to increased tax alpha, and so researchers may choose a backtest horizon that takes advantage of these periods. In the same vein, if you are examining tax alpha in a provider’s composite report, know that there is a lot of leeway in determining which portfolios get included in a composite. Some providers only include portfolios funded with cash in their composites, for example, which may serve to boost tax alpha.

READ MORE: The rise of “tax alpha” — 5 investing moves to make now

Second, there are many ways to calculate tax alpha, and you really have to be familiar with after-tax performance calculation methodology to put them all on equal footing. For example, one provider may show what’s known as a pre-liquidation figure, whereas another presents results post-liquidation. Providers may assume different tax rates in their calculations or strip out dividends, whereas others may make different assumptions. Other providers may present proprietary metrics that you’ve never heard of, leaving you to scour the footnotes to see how it was derived.

Finally, tax alpha is a very client- and portfolio-specific figure. It is the outcome of the direct indexing manager implementing a client’s unique tax objectives. For example, some clients prefer realized losses, some may value a tax-neutral approach; for others, the managed realization of gains is critical. In each case the direct indexing manager is providing tax alpha, but it manifests itself differently depending on the client and their unique circumstances.

Too much choice?
The second widely touted benefit of direct indexing is personalization. The idea here is that a direct indexing approach allows investors to tailor their portfolio to their values. If you don’t like stocks from a certain sector, for example, they can build a portfolio of individual stocks that excludes that sector. The alternative would be to find an ETF or mutual fund alternative that may or may not exist.

What I see happening with various direct indexing providers today is personalization being confused with overabundance of choice. The prevailing view of advisors and other practitioners I speak with is that the more “checkboxes” you can offer clients, the better. But who is to say that a provider offering an extensive list of possible customizations and exclusions is better than one offering a more limited list? I would argue that when evaluating a direct indexing provider based on allowable customizations, it is better to focus on how information is conveyed with an eye toward how it supports the decision-making process rather than the sheer number of options offered.

READ MORE: Direct indexing’s biggest lure isn’t a customized investment portfolio

For example, offering the ability to exclude the technology sector from a growth index is not all that helpful without seeing the resulting tracking error of the client’s portfolio. Similarly, allowing the ability to screen out numerous sectors, industries, ESG themes or others, is well and good until it reduces the investable universe to two stocks, which obviously isn’t great when trying to build a diversified portfolio. In either case, what needs to be associated with a list of customizations is information regarding the impact they may have on the risk of a portfolio. Only then can an advisor and client make an informed decision with regards to implementing any customizations.

So what does matter?
When I think of the most important aspect a direct indexing provider can provide, the word that comes to mind is partnership.

For example, how easy does a particular provider make it for you to do your job? What tools have they developed that fit into your workflows and how seamless are they? How can they help you come up with a plan that suits your clients’ unique and frequently changeable circumstances?  How easy are they to work with, and how responsive are their representatives? How do they help you communicate your value-add? 

Perhaps most importantly, how committed are they to helping your client achieve their goals?

The answers to these questions should give you an indication as to the kind of partner a prospective direct indexing provider will make. It is my belief that the best outcomes occur when all parties put the client first.



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