Abstract

Direct indexing as an investment product allows clients to hold individual securities that are part of an index, unlike a mutual fund or an exchange traded fund where client own shares of the fund but not the underlying individual securities within the fund.  It also offers additional flexibility, such as tax optimization and security level customization.

This article focuses upon multiple dimensions that a wealth firm needs to consider for offering direct indexing product & services to capture the growing demand for hyper-personalized portfolio and affordable tax optimized investments strategies.

Industry view

Recently, the industry had witnessed that asset under management (AUM) has increased multifold for direct indexing investments. The experts predicts that the direct indexing AUM will continue to grow for next few years, and its growth rate will be higher compared to other investment products such as exchange traded funds (ETF), separately managed accounts (SMA), and mutual funds (MF).

Industry has also seen an upsurge in merger and acquisition activity in this space where leading traditional asset & wealth management firms have acquired fintechs to build the underlying capabilities required to offer direct indexing solutions.

The key factors driving the demand includes, increase in client demand for highly personalized portfolio customizable at individual security level as per client values and investment preferences, desire for higher portfolio returns using tax efficient investment strategies, zero commission trading environment and technology advancements automating the manual intensive advisory functions.

Some of the key benefits of direct indexing delivered to clients includes, tax optimization, tax-efficient portfolio transition, personalized overlays, socially responsible investing, custom weighted indexing, lower expense ratios and charitable giving.

The industry adoption is still in early stages and only couple of wealth firms have started offering the direct indexing product and services to its clients and advisors.

Embracing direct indexing

Considering the demand for direct indexing investment and benefits it offers to the end clients, wealth management firms must include it as part of its holistic product and service landscape. The firms must evaluate multiple factors to build the product offering that is aligned to its strategic business priorities, advisory model and helps them to offer differentiating features to stay ahead of competitors.  

Some of the areas that the firms need to deliberate are discussed in the subsequent sections.

• Product strategy

The firms must decide upon the target segment for direct indexing services i.e., available to clients or advisors or both, followed by outlining the core value proposition such as choice of multiple indices, support for socially responsible investing (SRI); environmental, social, and governance (ESG), investment and tax efficiency strategies, pricing model including minimum investment threshold, advisory fees, and commissions etc. Firm must finalize the distribution channel i.e., fully digital versus the advisor led or hybrid advisory model as this will primarily impact the pricing model. In terms of the internal resources required firms will have to looks for strategic partnership with indices and market data providers, build and upgrade supporting technology platforms etc.

Firms must conduct a product fitment analysis and define a feature set aligned to its value proposition offered to client and advisors to meet their investment needs such as tax loss harvesting, charitable giving etc. For example, a firm evaluates a fully digital mobile app available to retail clients at affordable cost with lower investment threshold and allows portfolio customization based on couple of predefined indices.

• Business capabilities

Firms must evaluate the current business capabilities in context of the direct indexing and build a strategy to either update the existing ones or build newer capabilities. Some of the key business capabilities that needs to be evaluated in context of direct indexing includes, channels, investment planning, portfolio management, performance management, order management, trade processing, fees and commission and client reporting. Additionally, evaluate other areas such as client onboarding, market data, customer services, regulatory reporting, and product management. The high-level impact on select business capabilities is discussed in the subsequent sections.

For investment planning the advisors must be equipped to capture client values and investment preferences and construct a personalized index considering the choices of indices, SRI/ESG preferences etc.  The portfolio management must be geared to monitor the personalized index on an ongoing basis, rebalance the portfolio to manage the threshold drifts and to optimize the tax implication. The performance management will play an important role of tracking the portfolio performance against the personalized index and provide periodic consolidated performance reports to end clients.

The portfolio rebalancer must factor in parameters like client’ portfolio holdings, personalized index, market data to identify the tracking error i.e., drift from personalized index and trigger the rebalancing algorithm wherever the drift exceeds the predefined thresholds. The rebalancer must factor in the tax optimization strategies and generate buy and sell orders to realign the client portfolio with the personalized index.

The tax optimization must consider parameters such as client’ values, investment preferences, tax- profile, portfolio holdings, tax-lots, market data to identify the individual security holdings where there are opportunities for tax-loss harvesting and offset capital gains. The advisor must be equipped with an ability to configure the business rules and threshold values to enhance the insights generated by the automated tax optimizer algorithm. The advisor must have an ability to review orders generated by the tax optimizer algorithm before it sent to market for execution.

• Client journey

The client journeys will vary for each firm, based on the overall product strategy for example, delivering the services using fully digital mode or advisor led or hybrid model.  A typical client journey for an advisor led model is described below.

The advisor captures client’s goals, investment preferences, values, and existing portfolio as part of the planning process. Based on client’ context, the advisor proposes direct indexing product with choice of reference indices and collaborates with client to personalize index composition, primarily by excluding individual security from reference index (e.g., SRI, ESG) or modifying weights of certain securities (over or under allocation). The advisor finalizes the personalized index and obtains a client sign-off.

Once the client onboarding & funding activities are completed a portfolio is constructed based on agreed personalized index. As part of ongoing portfolio management activity, an automated system performs tax efficient rebalancing throughout the investment cycle with advisor oversight. Advisor conducts periodic reviews with client to refines investment strategies based on market conditions and client context. Advisor ensures that client receives periodic updates on portfolio performance against the personalized index.

In case of a fully digital model, firms must build best in class intuitive mobile app that offers superior customer experience and frictionless journey throughout from initial investment planning to ongoing investment management. Firms must build features like digital assistant, personalized videos, visually rich client reporting and educational content with the mobile app to further elevate the customer satisfaction.  

• Technology platform

Based on the direct indexing product strategy and initial business capability assessment, firm needs to decide upon an approach to build the required technology platform. Broadly, the assessment will result in categories like build newer or upgrade the existing capabilities. Firm needs to affirm its business case whether it wants to build a complete bespoke solution as per the unique value proposition or consider a third-party vendor platform and integrate with its existing applications. It is highly recommended that firms must do a detailed assessment of select vendor platforms and find the one that fits into firm’ business & technology context.

Firms must consider leveraging the larger ecosystem and look forward to partner with fintech and other business solution provider which offers underlying capabilities required to offer direct indexing solution. As one of the alternative approach the wealth management firms must consider is partnering with an external asset management company providing the direct indexing solutions, it will allow the firms to accelerate its product offering journey and reduce the time to market.

Conclusion

Direct indexing is not just another investment product but a solution that will allow the firms to elevate the customer satisfaction by enriching the overall investing experience. Firms must look forward to offer direct indexing solution and tap on client’s demand for the hyper personalized portfolios and tax efficient investment strategies. Firms will get benefited by delivering differentiated customer experience by offering client centric tailored solution customized to individual needs instead of traditional investment product such as exchange traded funds or mutual funds.

Looking at latest merger and acquisition trends firms must accelerate its journey towards building the required business capabilities. Firms must explore the ecosystem players like B2B service provider, fintechs, IT services partners and reduce the time of market to capitalize on early mover advantage.