Direct indexing strategies

As demand for personalized investment strategies grows, direct indexing emerges as a game-changer in wealth management. 

Direct indexing and customized investments are rapidly gaining momentum in wealth management, enabling wealth managers to craft highly personalized investment solutions tailored to individual client goals, values, and financial circumstances. As accessibility increases and demand grows, it’s important for wealth managers to understand the fundamentals of direct indexing, trends driving its growth, considerations for getting started, and benefits for your business. 

What is direct indexing?

In direct indexing, individual securities are purchased to replicate the performance of an index, rather than using a traditional exchange-traded fund (ETF) or mutual fund. For example, if an investor seeks exposure to the S&P 500, they can purchase shares of companies in the index that, the weights of which, are chosen to deliver performance similar to the index. This enables greater flexibility and personalization in portfolio customization. It goes beyond simply replicating the index, offering the following opportunities: 

• Personalization: Clients can align their portfolios with their personal values by excluding or overweighting specific sectors, industries, or companies. Direct indexing also allows for investment style-based personalization, where clients can select factor-tilted portfolios, focusing on factors such as quality, value, or momentum. Moreover, clients can restrict individual securities, such as when there is a conflict of interest or legal restrictions.
• Tax optimization: Wealth  managers can harvest tax losses by selling underperforming securities and replacing them with similar investments, offsetting capital gains and reducing taxable income. This can lead to significant tax efficiencies over time. Tax lot management is an additional strategy, enabling wealth managers to manage specific tax lots to minimize short-term taxes and emphasize long-term capital gains. This can lead to significant tax efficiencies over time.
• Risk management: Wealth managers can tailor portfolios to address unique risk preferences, liquidity needs, or concentrated stock positions.

Forces driving growth and adaptability

According to Cerulli Associates, direct indexing assets grew 41% in 2023, ending the year with $615 billion in total assets. While demand is high, only 18% of financial advisors report using direct indexing strategies, and another 23% have it available to them and plan to use the strategy.¹ They also noted in another report that direct indexing assets under management (AUM) are expected to surpass $1.5 trillion in 2025.²  

Technological advancements, such as tools for portfolio optimization, tax-loss harvesting, and ESG screening have made customization more accessible and scalable. Robo-advisors and digital platforms have helped open up opportunities for direct indexing beyond ultra-high-net-worth investors, enabling mass affluent investors to take advantage of the benefits. Rising demand for sustainable investing is also driving innovations in customized ESG solutions, adding to the growth and adoption of direct indexing.

Identifying potential clients

There are limitations to consider before you begin offering this to all clients. The minimum investments are still relatively high and the level of customization may also lead to higher management fees. Aside from the higher cost, there are other considerations to help you identify potential clients. Those who have the following characteristics may be more likely to consider a direct indexing strategy. 

• Seek personalization: Investors with strong ESG preferences or specific ethical values can benefit significantly from direct indexing and customized investment solutions.
• Have complex financial situations: High-net-worth individuals with unique tax considerations or concentrated equity positions often require bespoke strategies.
• Desire tax efficiency: Direct indexing is especially valuable for taxable accounts, where tax-loss harvesting can enhance after-tax returns.
• Focus on long-term goals: Clients with multi-generational wealth transfer plans or philanthropic goals may benefit from direct indexing and customized portfolios aligned with their legacy objectives.

A direct indexing strategy can help your clients better align their portfolios to reflect their values and goals and potentially provide significant tax savings over time. Clients also benefit from enhanced flexibility, allowing them to have greater control over their investments and adjust portfolios as circumstances change.

Getting started

To successfully implement a direct indexing strategy, consider these actions: 

1. Leverage technology: Invest in platforms that streamline customization, tax optimization and ESG screening.
2. Build expertise: Develop in-house expertise or partner with external providers to deliver high-quality customized solutions.
3. Educate clients: Explain the benefits and trade-off of these strategies to ensure informed decision-making.
4. Stay informed: Monitor industry trends, changes in investor demands, and regulatory developments to proactively manage and adapt your offerings. 

Navigating the regulatory and compliance landscape can be a challenge. As a fiduciary, be sure recommendations align with the client’s best interests and are based on thorough due diligence. Clearly communicate risks, fees, and potential implications.  As with any investments, a focus on data privacy is paramount. Be sure you are safeguarding sensitive client information used in personalization. And lastly, where ESG is involved, it’s critical to adhere to the evolving standards for ESG disclosures and provide the required substantiations about the social or environmental impact of a customized portfolio.

Benefits to your wealth business

The increasing accessibility and demand for direct indexing represents a paradigm shift in wealth management. Wealth managers can differentiate themselves in a very competitive market by offering opportunities for personalization, tax efficiency, and alignment with client values. As traditional investment products face fee pressures, customization offers wealth managers an opportunity to add value and maintain profitability through premium advisory fees. As the industry evolves, staying ahead of technological advancements and regulatory changes will be critical to success. 

Engaging in a personalized investment approach such as direct indexing also requires a heightened level of client trust. This ultimately helps you deliver differentiated outcomes and build stronger, deeper client relationships.

¹Cerulli Associates, “U.S. Product Development 2024: The future of funds of funds and defining direct indexing,” p. 45

²Cerulli Associates, "The State of Direct Indexing," 2023

The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional.

There are risks involved with investing, including possible loss of principal. Diversification does not ensure a profit or guarantee against a loss. ESG guidelines may cause a manager to make or avoid certain investment decisions when it may be disadvantageous to do so. This means that these investments may underperform other similar investments that do not consider ESG guidelines when making investment decisions. ESG and Sustainability are not uniformly defined across the industry.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties, which in certain cases have not been updated through the date hereof.  While such sources are believed to be reliable, neither SEI nor its affiliates assume any responsibility for the accuracy or completeness of such information and such information has not been independently verified by SEI. 

Information in the U.S. is provided by SEI Investments Management Corporation (SIMC), a wholly owned subsidiary of SEI Investments Company (SEI).

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