How Direct Index SMAs Can Help Wealth Advisers Grow Their Business
Thursday, October 12, 2023
October 2023
How Direct Index SMAs Can Help Wealth Advisers Grow Their Business

A rise in demand for direct indexing has shone a spotlight on the potential for personalized SMAs, helping investors and wealth advisers alike

By Anthony Marcozzi

Key Points

  • A rise in demand for direct indexing has shone a spotlight on the potential for personalized separately managed accounts (SMAs).
  • 82 percent of investors working with advisers are interested in personalized products. The product most interesting to investors craving personalization? Direct indexing SMAs. 
  • Only about half of managed accounts receive any tax treatment and only 16 percent are subject to the ongoing, systematic tax optimization indicative of direct indexing.
  • Advisers offering a high level of personalization and tax management capabilities may have a distinct advantage in competing for new business.

A couple of weeks ago, I wrote about how the recent meteoric rise of direct indexing has shone a spotlight on the potential for personalized separately managed accounts (SMAs) and I proposed that investors stand to benefit from investing in this strategy. 

Today, I’ll dive a little deeper by examining what’s in it for wealth advisers, who face a lot of competition to meet rising expectations from their clients for more holistic investment planning, putting a high premium on the levels of personalization and tax-efficiency found in direct indexed portfolios. 

What is an SMA? How is a direct indexed portfolio in an SMA different from a traditional SMA – and is it considered a passive or active strategy? And while we know that investors want to invest in direct indexing, how can offering this strategy impact a wealth adviser’s business? 

A Passive Strategy With Elements of Personalized Active Management

In simple terms, an SMA is a portfolio of securities that investors can invest in. It’s similar to an ETF or mutual fund, only when an investor invests in an SMA, they own all the securities within the portfolio, which is managed separately by a person or institution (usually a registered investment adviser) – in other words, think of SMA kind of like you would a mutual fund, only for a single client. 

Similar to mutual funds and exchange-traded funds (ETFs), SMAs can be used to invest in actively managed strategies (with the goal of beating an investment benchmark) and passively managed strategies (with the goal of matching an investment benchmark's performance). Direct indexing falls under this second bucket, as it is a passive investing strategy that enables direct ownership of the individual securities through an SMA, mirroring a specific index. 

Yet while holding a direct indexed portfolio in an SMA does mean an investor is engaging in a form of passive investing, that’s only a part of the story. The strategy can add complex tax management capabilities and its cherry-picking benefits enable investors to customize their portfolios to their unique specifications, introducing elements of personalized active management. In other words, passive investing, with active engagement. Therefore, calling direct indexed SMAs “personalized SMAs” might be more accurate.

Huge Opportunity for Wealth Advisers to Deliver Personalization at Scale

In my last article, I talked about how direct index SMAs can help investors build more personalized portfolios. But it’s not only investors who benefit from using this strategy – wealth advisers who offer this approach stand to grow their business.

Over 80 percent of investors working with advisers are interested in personalized products – and a whopping 62 percent are willing to pay more for this customization. And which investment approach is most interesting to investors craving personalization? You guessed it: Direct index SMAs.

It used to be that investing in an SMA happened mostly at the institutional level. But increased demand and advanced technology have led to lower costs, making the strategy accessible to a much wider pool of investors. And with assets in direct indexing projected to double from about $458 billion in 2022 to more than $800 billion by the end of 2026, wealth advisers can use it to provide their clients with a differentiated offering. As a senior leader of a fintech firm told research and consulting firm Cerulli Associates, “The collapse in trading fees has made a difference…Now you can do [direct indexing] at scale.”

Tax Optimization Can Help Wealth Advisers Competing for Business

In my last article, I talked about how investors who use direct indexing can tap into potential tax advantages, especially when there is high volatility in the market. The main tax management capability is tax loss harvesting, which is the selling of individual positions or tax lots when there’s an unrealized tax loss and then using the proceeds to buy similar securities or mitigate the risk of the portfolio.

What I didn’t talk about, however, is that executives expect that direct indexing through custom SMAs could produce an average tax alpha (the potential value created by the effective tax management of investments) of 100 basis points per year

At a time when there is high volatility in the market, the potential to generate this sort of after-tax performance could be very attractive to wealth advisers trying to stand apart from their competitors. Research supports this, showing that “only 53 percent of managed accounts receive any tax treatment, with only 16 percent to ongoing, systematic tax optimization.” Therefore, advisors offering this capability should have a distinct advantage in competing for new business.”

Another benefit that direct index SMA tax management brings is flexibility and control with how clients fund the account. With ETFs and mutual funds, clients typically purchase shares using cash, which may require liquidating some or all of their existing holdings and potentially generating a needlessly high tax bill. When funding a direct index SMA, advisers and clients can use both cash and/or existing securities to fund the account and sophisticated advisors, like Ethic, can run a tax transition which can help navigate the complexities of minimizing the client’s tax bill and getting to an index-tracking SMA.

Every investor has different goals and values, so it makes sense that they would want a strategy that caters to their unique investment journey, with a focus on personalization and tax enhancements. Direct index SMAs can potentially enable wealth advisers to support these sorts of individual investor journeys at scale, while giving them a distinct advantage in competing for new business.

Contact your relationship manager to learn more about how Ethic can help you and your clients build a direct indexing portfolio.

What’s a Rich Text element?

The rich text element allows you to create and format headings, paragraphs, blockquotes, images, and video all in one place instead of having to add and format them individually. Just double-click and easily create content.

Static and dynamic content editing

A rich text element can be used with static or dynamic content. For static content, just drop it into any page and begin editing. For dynamic content, add a rich text field to any collection and then connect a rich text element to that field in the settings panel. Voila!

How to customize formatting for each rich text

Headings, paragraphs, blockquotes, figures, images, and figure captions can all be styled after a class is added to the rich text element using the "When inside of" nested selector system.

Sources and footnotes

Ethic Inc. is a Registered Investment Adviser located in New York, NY. Registration of an investment adviser does not imply any level of skill or training. Information pertaining to Ethic Inc’s registration or to obtain a copy of Ethic Inc.’s current written disclosure statement discussing Ethic Inc.’s business operations, services and fees is available on the SEC’s Investment Adviser Public Information website – www.adviserinfo.sec.gov or from Ethic Inc. upon written request at support@ethicinvesting.com. Information provided herein is for informational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Any subsequent, direct communication by Ethic Inc. with a prospective client shall be conducted by a representative of Ethic Inc. that is either registered or qualifies for an exemption or exclusion from registration in the state where a prospective client resides. Information contained herein may be carefully compiled from third-party sources that Ethic Inc. believes to be reliable, but Ethic Inc. cannot guarantee the accuracy of any third-party information.

Ethic Inc. does not render any legal, accounting, or tax advice. Ethic Inc. recommends all investors seek the services of competent professionals in any of the aforementioned areas. Ethic Inc. cannot provide any assurances that any investment strategies, simulations, etc. will perform as described in our materials. ALL INVESTMENTS INVOLVE RISK, ARE NOT GUARANTEED, AND MAY LOSE VALUE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY.

Contributors

Anthony Marcozzi is a proud born and raised New Jerseyan. Previously Anthony worked at UBS in the Global Wealth Management Division and most recently worked on the sustainable investing solutions team with a focus on growing the ESG product set and educating financial advisors. He holds the Chartered Sustainable, Responsible and Impact Investing Counselor (CSRIC™) designation and graduated from Bucknell University with a B.S. in Managing for Sustainability.