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Direct or Personalized Indexing: Not Just for Passive Investing

Direct indexing can improve after-tax returns of certain active strategies, not just passive ones.

Interest in direct indexing has become white hot since the recent acquisitions of Eaton Vance / Parametric by Morgan Stanley and Aperio by Blackrock. With direct indexing, one buys the individual stocks in an index, instead of a fund that tracks the index. The term direct indexing is sometimes also used when constructing a custom portfolio out of individual stocks—instead of ETFs or mutual funds—with the goal of achieving certain exposures, but without necessarily tracking an index.

The direct indexing benefits that have garnered the most press are the ability to improve the ESG (environmental/social/governance) score of the portfolio, and the higher, on average, tax efficiency of tax-loss harvesting of single-stock portfolios relative to ETF-based ones.

Moreover, though, direct indexing allows asset managers to augment certain active strategies with the increased after-tax returns of direct indexing. When you think about it, many active strategies are similar to a stock index: long-only, only liquid exchange-traded securities (e.g. no derivatives), holdings in many stocks, and weights that do not change too frequently.

Here’s a key caveat: employing direct indexing on such a custom index works best for active strategies that target a large slice of the market, such as growth or value. This is because the tax-loss harvesting component of direct indexing works, roughly speaking, by harvesting (selling) stocks at a loss, and replacing them with similar stocks. Replacing one growth stock with another will not significantly change the objective of an “overweight growth stocks” strategy. On the other hand, the approach may not work for more stock-specific active strategies, where perhaps it is not acceptable to replace one stock with another. Still, this leaves many situations where active direct indexing provides a benefit.

You may wonder: “what is the difference between applying direct indexing rules on a well-known stock index, versus a custom index in this example?” In theory, none. In practice, care must be taken to ensure that direct indexing will work on this new “index”, and not cause, for example, too much trading or too much tracking error. It’s a bit like an FAA certification for aircraft: even a small change in the behavior can produce very different results, as was unfortunately shown by the Boeing 737 Max disasters.

However, just like FAA certification of an aircraft, verifying that direct indexing will work correctly with an arbitrary stock index, and tuning it to do so, is typically a manual and lengthy process. Technology can help with this. To extend the flight analogy, it’s like running many simulations on a computer under many scenarios before actual flight testing.

The non-trivial process of moving from pooled investment vehicles to separately managed accounts is the elephant in the room—but only a small, Dumbo-sized one. In the last few years, the technology for “robo”-style investing has matured. Software can inspect accounts at any frequency—even daily—and trade automatically when needed. Changing the ‘wrapper’ on the same underlying product (the alpha of the active strategy) will take some effort, but that can be more than offset by the benefits of direct indexing.

A second benefit of full automation is that it can also be used for validating the correctness of direct indexing as applied to one particular client. In the same way the selection of an index affects the performance of direct indexing, a client’s specific situation will also matter. Examples would include tax brackets; expectations of future external gains or losses; preferences (such as for harvesting losses vs. not trading too frequently); expectations of future deposit patterns; assets held away; etc.

Most of the attention received by direct indexing has been in the context of passive investing. With the right technology, active managers can use direct indexing to increase the after-tax returns of clients, in addition to its other benefits.

Iraklis Kourtidis is the founder and CEO of Rowboat Advisors, which builds investing software for separately managed accounts with a focus on tax efficiency and direct indexing. He also built the first fully automated version of direct indexing in 2013 for automated investment service Wealthfront.

TAGS: Technology
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