Working with direct indexes should be as easy as working with ETFs

We’ve previously talked about why direct indexes are getting so much attention (see Why All the Direct Index Acquisitions). But if you’re a wealth advisor, how do you implement direct indexes? How, as a practical matter, do you go about incorporating them into your workflow? 

The answer is not giving your client-facing advisors better rebalancing tools. Managing taxes and customization — while controlling drift and risk — is complicated, and most advisors don’t do it efficiently or well. Worse, it’s a bad use of their time. The most practical way to incorporate direct indexes into your practice is to delegate the job to internal or external specialists. Most firms will just outsource managing direct indexes to a third party, though larger firms can choose to create an internal service group. 

Now comes a twist. The current industry-standard approach to implementing direct indexes is to use separately managed accounts (SMAs); that is, you hand the direct index portion of the account to a specialist third-party manager. But this approach has two shortcomings: 

First, it’s not optimal for tax and risk management. If you embrace direct indexing, you’re buying into the advantages of customization and tax management (as well as the need to control their risk impact). However, taxes and risk are features of portfolios as a whole, not just the direct index portion. Direct index SMAs do a pretty good job of tax managing themselves, but you can do better if you manage tax and risk holistically at the portfolio level.  

Second, working with direct index SMAs is time consuming and therefore expensive. With direct index SMAs, otherwise ordinary tasks — like account opening, account closing, investing new cash, implementing cash out requests, wash sale avoidance across the entire portfolio, and asset class rebalancing — require a separate workflow. For example, every time there’s a client cash out request, you have to figure out how much comes from the direct index manager and how much comes from the rest of the portfolio. All this complicates your workflow and takes time. For many advisors, it’s not worth the cost and hassle.

The good news is that there is a way to embrace direct indexes that avoids these shortcomings: upgrade from direct index SMAs to unified managed accounts (UMAs) with direct index cores. The idea is similar, but you let whoever is managing the direct index manage the entire portfolio. This keeps ordinary tasks simple — you just let the UMA manager take care of it. In this way, managing direct indexes literally becomes as easy as managing ETFs. Embracing direct indexes needn’t make your operations more complex — it can even make your operations simpler.

You might object that delegating management of the whole portfolio means a loss of control over asset allocation and product choice. This is not true — you can outsource rebalancing, tax management, customization, implementation and trading while retaining full control over strategy. Assuming the UMA provider has the tools to quickly implement strategy changes across a customized book of business, outsourcing will, counterintuitively, increase rather than decrease your control. 

And once portfolio rebalancing is delegated, there are no longer barriers to investor-facing advisors offering customization and tax management to every investor. This means: 

• Every account can have ESG or religious screens.
• Every account can have risk customization (e.g. if you work for Exxon, eliminate energy stocks from the portfolio).
• Every account can have tax-smart transitioning, year-round loss harvesting and risk-compensating gains deferral. 

Delegating the day-to-day management of the portfolio does come with one cost. It’s incompatible with old-style value propositions based on trade-by-trade conversations with clients, but for most firms, this is a plus. It replaces the unreliable quest for market-beating performance with solid, customized, low-cost, tax efficient investing, which becomes a backdrop for the advisor's main role — acting as the investor’s financial coach and guide. 

Direct indexing is getting attention because direct indexes offer investors more customization and better tax management. For most firms, working with mutual funds and ETFs is still easier, and this is a barrier to direct index adoption. But this is changing, and as it does, we foresee direct indexing becoming the norm. 

SAM and direct indexes

SAM offers both direct index separately managed accounts (SMAs) and unified managed accounts (UMAs) with direct index cores. With UMAs, the client wealth advisory firm retains control of asset allocation and product choice — including the option to subscribe to third-party asset allocation models. (SAM recently announced that it includes in its base offering asset allocations and direct index portfolios tied to Morningstar indexes.)

^{1 While the central group is responsible for implementing customization, the knowledge of what customization each client needs and wants can only come from the client-facing advisor. So the advisor needs to give the specialist rebalancing group customization instructions for each account. Ideally, this is done through a customization portal, but any written communication, even a simple pdf, will do (writing down all customization requests has utility for compliance, as well, but that’s another story).}