How to Make Direct Indexing Work at Scale

By Lauren Yeaton Hunt, VP, Product Marketing


There’s a new movement on Wall Street: a wave of assets leaving mutual funds, especially among high-net-worth investors. According to Cerulli Associates, advisors anticipate reducing their use of mutual funds by 12% and increasing their use of SMAs by 19% from 2020 to 2022.1

Where are these assets going? According to Cerulli, SMAs. "A combination of surging interest in direct indexing and HNW clients' needs for customization and tax-smart investing is propelling SMAs for strong growth. An improved client experience makes it easier for advisors to implement managed accounts in client portfolios, a trend upon which asset managers launching these products are looking to capitalize."

In addition, changes such as the declining cost of equity trades and innovations such as the ability to own and transact in fractional shares are bringing this revolution to the mass-affluent market.

Facilitating personalization and tax-optimization

Many investors, particularly the wealthier ones, have long chafed at the inability of active or passive funds to accommodate personal preferences, be they for factor tilts or environmental, social and/or governance (ESG) concerns.

Then there are taxes. The burden of capital gains is shared by the fund holders; when assets must be sold at a profit (to meet distributions), the investors take the tax hit. On the other hand, aggregation denies investors the ability to reap the losses for individual tax optimization, and every year, the capital gains distribution number comes as an unwelcome surprise. This is a conversation clients don’t like to hear and advisors don’t like to have each year-end.

Both personalization and tax-optimization require direct ownership of the underlying securities in the individual investor’s account – and that’s precisely what direct indexing is all about. In an environment in which trading fees are converging to zero, clients can own the equities in the index, or through optimization, own a subset of the securities in the index that represent their preferences, social goals or chosen tilts, while still maintaining some reasonable tracking to a benchmark. At the same time, the portfolio can be managed to leverage losses for reduced taxation.

In an April 2021 whitepaper, a Cerulli research director for managed accounts noted, “Several developments have created the opportunity to expand tax optimization to a broader set of clients, hopefully allowing the industry to deliver on the promise of tax customization through direct indexing. The disappearance of brokerage commissions eliminates the trading fees resulting from the high turnover of personalized indexes.2

How to make direct indexing work – at scale

Asset managers are paying attention. In 2020, ESG solutions jumped to the top of asset managers’ priority lists.

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But here’s the rub: managing, trading and rebalancing portfolios for individual ESG preferences and tax optimization across hundreds or thousands of accounts is very difficult to scale without a comprehensive and sophisticated backend system, especially as firms contemplate bringing these solutions beyond the HNW investor market.

The bad news: All this is difficult, with a complexity that grows with scale – the scale asset managers need to make SMAs profitable. Managing personalization and tax optimization efficiently at scale for thousands of accounts across multiple distribution platforms fundamentally requires automated workflows, reconciled, consistent, real-time holdings and tax lot data, and extensive connectivity to all major custodian and sponsor firms.

The good news: Vestmark has just released a new white paper to guide you: Direct Indexing Strategies at Scale: A Practical Approach for Investment Professionals.

We’ve identified the biggest obstacle facing asset managers interested in direct indexing – scale – and have created a paper that defines the challenges, articulates the solution, and offers a practical pathway forward. Inside the paper you’ll find answers to key concerns such as launching direct indexing products, improving partner connectivity, and managing workloads at any volume.

Today’s savvy investors are flocking to direct indexed SMAs; be prepared to greet them efficiently, effectively – and profitably.

1 Cerulli Edge US Managed Accounts Edition, 2Q 2021.
2 Cerulli Associates, Direct Indexing and the Unfulfilled Promise of Tax Efficient SMAs, April 2021.

By Lauren Yeaton Hunt, VP, Product Marketing