How to talk to clients about direct indexing

As a financial advisor, staying ahead of investment trends is essential. One strategy that's been gaining attention is direct indexing. 

Understanding and explaining its benefits can help you better serve your clients and enhance your expertise.

What is direct indexing?

Direct indexing involves buying individual stocks that make up an index, rather than investing in a traditional index fund or ETF. This strategy offers more flexibility, allowing investors to customize their portfolios to better suit their financial goals and preferences. 

One key benefit of direct indexing is tax loss harvesting, which enables investors to offset capital gains by selling securities at a loss. This makes it particularly attractive for clients focused on tax efficiency. Additionally, direct indexing allows for personalized portfolio adjustments, such as excluding specific sectors, industries, or individual stocks. This is especially beneficial for investors who want to align their investments with their personal values or ethical considerations.

How to explain direct indexing to clients:

1. Simplify the concept: Clients may not be familiar with the intricacies of direct indexing, so it’s important to explain it in simple terms. Start by comparing it to traditional index investing. Explain that while traditional index funds pool investments into a single fund that tracks an index, direct indexing allows them to own the individual stocks that make up the index directly.
2. Emphasize the benefits: Clients often care about three things: achieving their financial goals, risk vs. return, and tax efficiency. Highlight how direct indexing can improve each of these factors. Explain that direct indexing offers more potential for tax savings (through tax loss harvesting), more flexibility in terms of portfolio customization, and the possibility for better after-tax returns.
3. Discuss costs: While direct indexing typically carries higher costs than a low-cost ETF, it's important to highlight that the potential tax benefits, such as tax loss harvesting, can often outweigh these costs over time.
4. Provide examples: Using examples can help make direct indexing feel more tangible. For instance, you could show them a model portfolio that illustrates how a direct indexing approach might outperform a traditional index fund after taxes, or how a client could avoid investing in industries they don’t support.

When might direct indexing be right for your clients?

Direct indexing may be an ideal strategy for clients who:

• Seek to optimize their tax strategy
• Want greater control and customization in their portfolios
• Prefer to avoid certain industries or companies in their portfolios

Before recommending direct indexing, assess whether your client’s financial goals, risk tolerance, and investment preferences align with the strategy.

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.

Investing involves risk including the potential loss of principal. Tracking error risk is the risk that the performance of a portfolio designed to track an index may vary substantially from the performance of the benchmark index it tracks as a result of cash flows, portfolio expenses, imperfect correlation between the portfolio's and benchmark's investments and other factors. This risk is magnified when sampling a benchmark index as the strategy may not track the return of its benchmark index as well as it would have if the strategy purchased all of the securities in its benchmark index.

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

SIMC does not represent in any manner that the tax consequences described as part of its tax-management techniques and strategies will be achieved or that any of SIMC's tax-management techniques, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-management techniques, including those intended to harvest tax losses, and other strategies that SIMC may pursue are complex and uncertain and may be challenged by the IRS. Neither SIMC nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax, penalties and/or interest which may be imposed by the IRS or any other taxing authority; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor. Accordingly, Clients should confer with their personal tax advisors regarding the tax consequences of investing with SIMC and engaging in the tax-management techniques described herein (including the described tax loss harvesting strategies) based on their particular circumstances. Clients and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the Client's personal tax returns. SIMC assumes no responsibility for the tax consequences to any Client of any transaction.