Leading financial advisors are accelerating their adoption of custom separately managed accounts and direct indexing technology to optimize the tax efficiency of client investments. According to a pair of experts from Allspring, clients are quickly catching on to the excess value these advisors are delivering.
This was the main conclusion of a recent webinar hosted by Allspring executives Katie D'Angelo, head of global relationship management, and Manju Boraiah, head of systematic edge fixed income and custom separately managed accounts.
According to the Allspring duo, more advisors are coming to realize there are big opportunities to collaborate with innovative investment managers to deliver superior after-tax returns on the equity side of the portfolio, but fewer are aware of the opportunities that can present themselves with clients' fixed income holdings.
Ultimately, D'Angelo and Boraiah suggest, direct indexing represents one of the fastest-growing and most promising investment methodologies for both stocks and bonds, and its use can be attractive to all manner of clients seeking more personalized and responsive portfolios.
Direct Indexing Basics
In its purest form, direct indexing on the equity side is the process of replicating an index's performance through owning its underlying securities individually, as opposed to buying them collectively via mutual funds or ETFs. For example, an investor could attempt to track the S&P 500 Index by purchasing an S&P 500 direct index separately managed account (SMA).
The portfolio would typically hold a representative sample of securities in the index, the experts note, optimized to mimic its risk and return characteristics. The portfolio is rebalanced and reconstituted periodically in alignment with the index, and unlike mutual funds and ETFs, direct indexing offers its investors direct ownership of the securities in the portfolio.
This provides them with several key advantages, including greater control, flexibility and personalization of portfolio holdings that may be customized to align with their individual goals. And, because the investor directly owns the underlying securities, it allows for enhanced, proactive and ongoing tax management capabilities.
Direct indexing on the fixed income side works somewhat differently in that there are no indices to be replicated, per se, but the same responsiveness and flexibility opens up what the Allspring experts called "intriguing" opportunities to pursue highly tailored investment goals via customized blends of bonds.
Overall, as awareness grows and usage broadens, the Allspring experts anticipate that direct indexed SMA assets could balloon from an estimated $260 billion at the end of 2022 to $825 billion by 2026. Investors using such strategies, the pair suggest, can expect to reliably achieve between 30 and 50 basis points of excess annual returns — and even more in some special cases.
Direct Indexing and Equities
As D'Angelo and Boraiah point out, equity returns are always difficult to predict, while the amount of portfolio risk is somewhat easier to model — though it is still reliant on estimates and models.
Tax alpha, on the other hand, is relatively more transparent in the context of direct indexing.
"Because investors have direct ownership of the portfolio securities, there are countless chances to exploit volatility and generate tax alpha throughout the life of a portfolio, especially compared with traditional funds," Boraiah says. "Investors may do this by taking advantage of unsystematic risk and isolated stock movements."
In basic terms, unsystematic risk refers to risks that are not shared with the broader market. That is, they are attributed to individual securities.
Therefore, while a portfolio's value can increase, Boraiah explains, some of its underlying positions may have losses that present opportunities for tax-loss harvesting. This generally isn't possible when clients are investing via traditional mutual funds, Boraiah explains, but modern direct indexing approaches make it (relatively) straightforward.
