Unlocking the Power of Direct Indexing with SMAs

By Vestmark Inc., Resources

Vestmark Blog Unlocking the Power of DI SM As Hero 2880x1000

Direct indexing has grown in popularity as more and more advisors seek to provide low-cost and personalized solutions to their clients. In fact, direct indexing is projected to grow 12.3% annually, reaching a total asset value of $825 billion by the close of 2026 according to Cerulli Associates.1

Most providers and researchers agree on the potential benefits of direct indexing, the primary one being tax management and the opportunity for better after-tax performance. However, there is debate among providers regarding the potential benefits of using Separately Managed Accounts (SMAs) for direct indexing vs. managing indexes without any sleeves, partitions or subaccounts.

At Vestmark, we believe SMAs are the preferred vehicle for direct indexing when managed with the right technology within a UMA framework. Recently, Robert Battista, CFA, Head of Advisory Solutions at Vestmark, shared his views with Digital Wealth News (DWN) on the topic. Below is a transcript of that Q&A as published on April 2, 2024.

Portfolio solutions providers differ on the potential benefits of using Separately Managed Accounts for direct indexing (DI) because the subaccount-based approach supposedly adds unnecessary complexity and cost to the management process. Explain why this is not true.

The argument against using Separately Managed Accounts (SMAs) for direct indexing (DI) due to added complexity and cost doesn’t hold up when there are platforms that allow financial advisors to easily manage sleeves or subaccounts.

Those who argue against SMAs may not be aware that the right Unified Managed Account (UMA) technology allows subaccounts to be managed easily. With UMA technology, an index does not have to be managed separately from the portfolio. Advisors can rebalance, tax-loss harvest, manage wash sales, substitute securities or impose restrictions at the account level in an automated way. Additionally, an advisor can report against individual aspects of the portfolio to provide clients with more transparency into the individual investment vehicles within the portfolio.

What is your definition of a holistic approach to tracking portfolio performance and tax efficiency, and how does Vestmark make it possible for this type of optimization to be feasible with separate subaccounts/SMAs?

A holistic approach to tracking portfolio performance and tax efficiency involves considering multiple factors such as personalized tax management, alignment with client preferences and values, and addressing unique financial situations. We believe managing portfolios containing direct indexes holistically – utilizing UMA technology – is the preferred approach. By leveraging subaccounts or ”sleeves” of direct indexes, SMAs and other vehicles, Vestmark’s technology helps streamline portfolio management and enhance personalization at scale.

Vestmark’s UMA technology allows for sophisticated tax management and optimization capabilities. We store individual tax rates, tax budgets, and perform ongoing tax optimization at the individual level. Features like tax-loss harvesting are seamlessly integrated into Vestmark’s platform, helping advisors to potentially reduce taxes on investment gains and enhance after-tax performance for clients.

What are the disadvantages of a sleeveless approach in portfolio management, and how can greater flexibility and customization be realized using SMAs for direct indexing? Can advisors still expect precise asset-class rebalancing, tax loss harvesting, and gains deferral within individual subaccounts?

A sleeveless approach, where all assets are commingled within a single account, can have several disadvantages compared to utilizing UMA technology with SMA subaccounts for direct indexing. SMAs facilitate precise asset-class rebalancing within individual subaccounts, helping to ensure that portfolios maintain their target allocations over time. They also allow for more accurate performance tracking of each individual investment.

This level of granularity may be challenging to achieve in sleeveless portfolios, where assets are grouped together, making it difficult for advisors to rebalance efficiently without triggering unintended tax consequences. Proponents of the sleeveless approach say eliminating partitions makes it easier to manage after-tax, tracking error-adjusted returns. It’s simpler and less expensive, they claim.

But we believe that with the right platform, it’s possible to manage portfolios easily, keep the integrity of data in sleeves and also offer sophisticated account level optimization.

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There is no assurance that a separately managed account (“SMA”) will achieve its investment objective. SMAs are subject to market risk, which is the possibility that the market values of the securities in an account will decline and that the value of the securities may therefore be less than what you paid for them.

UMAs are not suitable for all investors and should be evaluated for suitability by their Financial Professional prior to investing.

There is no assurance that investment products based upon indices will accurately track index performance or provide positive investment returns. Inclusion of a security within an index is not a recommendation by VAS to buy, sell, or hold such security, nor is it considered to be investment advice.

Investment strategies that seek to enhance after-tax performance may be unable to fully realize strategic gains or harvest losses. Tax-loss harvesting involves the risks that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit.

By Vestmark Inc., Resources