Written by: Andrew Gradus, Senior Director, Consulting
Direct indexing is more popular than ever before and is on track to outpace the growth rate of ETFs and Mutual Funds over the next five years. However, direct indexing can also be incredibly challenging for firms and advisors to efficiently manage on their own. Traditionally, there are two ways to incorporate direct indexing within an investment portfolio: downloading a spreadsheet of holdings to rebalance and trade or using a separate account. Both approaches come with significant logistical and administrative challenges, putting direct indexing out of reach for many advisors and their clients.
As a result, many advisors turn to so-called “turnkey algorithm solutions” that promise to facilitate the portfolio customization process. The reality is, these DIY solutions rarely provide the support and active management that is needed for a direct indexing strategy to actually be efficient, scalable, and profitable.
In this blog, we’ll outline some of the challenges of DIY direct indexing in the absence of a UMA and overlay manager — and discuss how Adhesion Wealth’s solution is leading the way in making direct indexing easier for advisors to offer to their clients and to incorporate into their portfolios.
The Problem With Relying on Spreadsheets
The central goal of direct indexing is to build a portfolio that imitates a mutual fund or ETF while maintaining all the flexibility of holding each security separately. S&P 500 funds or index mutual funds are typically comprised of hundreds of different positions, making it incredibly hard to replicate. Trying to manage this using a spreadsheet is often unsuccessful due to the many interconnected parts such as, but not limited to, taxation, inflows, outflows, and potential for wash sales. As a result, it is difficult for many financial firms and advisors that lack the resources or time to manage such complex portfolios, as the logistical and administrative challenges are just too steep.
Why Using a Separate Account Isn’t Much Better
When a direct index is placed in a separate account, investors and advisors end up having multiple portfolios to keep track of, creating an administrative nightmare and making it more challenging to manage potential wash sales. If a client has a pool of money allocated over various separate accounts, one hand might not know what the other is doing, frequently resulting in disallowed losses due to wash sales that end up penalizing the investor. The full impact of these disallowed losses will often not be understood until a client is working with their tax preparation firm.
This brings us to the third challenge associated with direct indexing in the absence of a UMA and overlay manager: tax management.
The Challenge of Tax Management
Unforeseen tax consequences can often occur when well-meaning changes to taxable portfolios are made, most commonly in the form of significant unrealized gains and losses. As an advisor, whether being tasked with adding new client assets or making changes to existing strategies, you need a reliable and easy way to migrate taxable client portfolios effectively while minimizing tax liability and maximizing tax alpha. A direct index utilized within a UMA has the potential to offer distinct advantages by enabling active tax-loss harvesting, gains deferral from withdrawals, and the ability to absorb legacy holdings and positions sold by other managers.
The Adhesion Wealth Difference
Turnkey algorithm solutions often promise simplicity and ease of operation but fail to deliver and do not capture the true value of direct indexing. At Adhesion Wealth, our team has been working for years to make direct indexing more readily available to advisors and clients alike. One way we’ve gone about this is by applying an optimizer that distills down an index into fewer holdings that replicate the greater whole. This optimizer captures the characteristics and attributes of the index in a much smaller sample size, which makes it easier to manage and more accessible for smaller clients.
Adhesion’s Unified Managed Account capabilities are the foundation of our direct indexing services. This allows a direct index to be placed at the core of an account, with satellite holdings wrapped around it. The Adhesion Investable Index Series shows how our direct index strategies can provide low-cost, tax-aware portfolios that focus on tax-loss harvesting while demonstrating index-like tracking characteristics—with the potential for generating positive results.
Our tax overlay management services can help advisors identify the most advantageous ways to facilitate trading at both the sleeve and account levels. Our approach is to employ tax-loss harvesting year-round to take advantage of losses whenever market conditions warrant.
Although direct indexing can be a daunting task for many advisors if they try the DIY approach, Adhesion Wealth’s solution is designed to make it easy. Through our scalable UMA capabilities, we combine a highly personalized investment experience with the performance of direct indexing—and bring it down to smaller accounts and households. Let us show you how easy direct indexing can be with the right partner.