Too few financial advisers are aware of direct indexing, an investment approach gaining traction for its tax efficiency and customisation.
Every financial adviser will be all too familiar with managed funds and ETFs, allowing them to invest in a pre-selected group of stocks, typically to track a market index. However, far fewer are aware of direct indexing, an
approach that also aims to track an index’s performance but offers tax efficiency and customisation options that ETFs and managed funds simply cannot accommodate.
Direct indexing has seen a meteoric rise in popularity, with assets reaching an impressive US$864.3 billion by the end of 2024 according to Cerulli. While this figure is still dwarfed by the US$9.4 trillion held in ETFs in the United States alone, the growth of direct indexing has far surpassed industry expectations.
This raises the question: why is direct indexing gaining such traction, and what does the future hold?
The future of low-cost investing is customised
There is no doubt that ETFs have revolutionised the funds management industry with their accessibility, low cost, and transparency. However, direct indexing is a formidable competitor, blending the customisation of stock picking with the simplicity and diversification of ETFs. This approach allows investors to own a personalised basket of securities that track a chosen benchmark, managed daily by the latest advancements in portfolio management and asset allocation technology.
Direct indexing enables financial advisers and investors to create tailored investment portfolios by directly purchasing the individual components of an index, rather than investing in a pooled vehicle like an ETF. This offers opportunities to optimise after-tax outcomes, incorporate impactful themes such as sustainable and socially
responsible investing, as well as providing precise control over portfolio construction to align with individual client goals.
It offers a range of benefits that make it an attractive option for investors and financial advisers seeking a more personalised and efficient approach to portfolio management.
What makes direct investing unique?
One advantage of direct indexing over typical index funds and ETFs is the ability to customise portfolio holdings. While index ETFs come as a package deal – typically including every stock in the index – direct indexing allows an investor to tailor their investments to better match their own individual financial goals or personal values.
For instance, if your client is an environmentally conscious investor, direct indexing can help you exclude companies with high carbon emissions. Alternatively, if they feel overexposed to a particular stock or sector you consider risky, direct indexing enables you to diversify around that position to mitigate risk.
In close collaboration with their financial adviser, an investor can make portfolio adjustments as needed. These may include asset allocation changes, capital contributions and redemptions, as well as changes in investor preferences.
The tax benefit
One of the most significant advantages of direct indexing is the ability to implement a strategy known as tax-loss optimisation. This involves selling underperforming positions to crystallise portfolio losses, which can then be used to offset capital gains from other investments, including those in different asset classes or managed by other entities, which can potentially reduce an investor’s tax liability.
Some direct indexing platforms offer a fully automated solution to continuously and opportunistically crystallise tax losses throughout the year, and not simply at financial year end, while continuing to track the index performance as its objective. Importantly, tax-loss optimisation is generally not feasible with index-tracking funds or ETFs because investors own units of the fund rather than the individual securities.
This novel approach can potentially help reduce the overall tax burden for the investor, without compromising total portfolio performance.
Control, transparency and cost effectiveness
Direct indexing provides investors with more control. Investors can adjust their holdings to better align with their financial goals and risk tolerance. This level of control is not possible with pooled investment vehicles like mutual funds or ETFs.
Investors also have full visibility into the individual securities they own, which enhances transparency. This allows for better understanding and monitoring of the portfolio’s performance and alignment with personal values and objectives, as well as supporting engagement between the financial adviser and investor.
Rapid advancement in technology and the availability of low-cost trading have made direct indexing more accessible and affordable. These factors have significantly reduced the costs associated with buying and managing individual securities.
Reducing risk
Direct indexing also allows for a high level of diversification by replicating the performance of a broad market index. This helps spread risk across a wide range of securities, reducing the impact of any single stock’s performance on the overall portfolio. Furthermore, many investors with highly concentrated stock portfolios may see a benefit in migrating to a direct indexing approach to somewhat hedge against idiosyncratic stock risk.
It also offers flexibility in portfolio construction and management. Investors can easily adjust their holdings in response to changing market conditions or personal circumstances, ensuring their portfolios remain aligned with their evolving goals.
The use of technology can also allow advisers to offer extensive personalisation to their clients and allow for specific adjustments based on client preferences such as social responsibility or avoiding certain industries or stocks. Portfolio monitoring capabilities reduce the compliance workload for advisers who periodically rebalance each client portfolio.
The future
Direct indexing represents the future of customised investing in Australia. By merging the benefits of index investing with the ability to personalise portfolios, it offers a compelling solution for both investors and financial advisers looking to differentiate their client offering. As the demand for bespoke investment strategies continues to grow, direct indexing is poised to lead the way, presenting a new standard for personalised investment management.
Josh Persky is chief executive at Briefcase.
