Introduction to direct indexing

Investors are on the lookout for cost-effective, hyper-personalized portfolios and tax-optimized investment strategies.

Direct indexing offers strategic approaches by allowing investors to hold individual securities that are part of an index. Unlike a mutual fund or an exchange-traded fund (ETF) where clients own shares of the fund, direct indexing allows an investor to own the underlying individual securities within the fund. Additionally, it offers greater tax efficiency and security level customization.

Direct indexing has benefits for taxes and philanthropy, such as: tax optimization, tax-efficient portfolio transitions, personalized overlays, socially responsible investing, custom-weighted indexing, lower expense ratios, and charitable or philanthropic giving. While these factors drive investor demand, zero-commission trading and increasing automation of advisory functions are other strong drivers for the rise of direct indexing.

As the assets under management (AUM) for direct indexing have increased, asset and wealth management firms are hoping to capitalize on its growth. Experts predict that this trend will continue in the coming years, overtaking the growth rates of other investments such as ETFs, separately managed accounts (SMAs), and mutual funds (MFs). To get a head start, some traditional asset and wealth management firms have acquired fintechs offering direct indexing solutions—an indicator of the potential of this area. However, despite significant growth potential, the adoption of direct indexing is still in its early stages as only a few wealth firms offer products and services.

Why we recommend direct indexing

Direct indexing investment products offer retail wealth management clients numerous benefits.

Firms must evaluate multiple factors and build products, so they align with strategic business priorities and advisory models. Clearly, various factors such as product strategy, business capabilities, and more will need to be kept in mind while defining the approach for designing direct indexing products.

Our approach to direct indexing

To launch a direct indexing product, wealth management firms must evaluate key factors.

The factors listed below will impact overall business objectives and strategies, and will help businesses arrive at the right approach.

Product strategy: The first step is for firms to identify the target segment for direct indexing services. This includes clients, advisors, or both. Next, they must outline the core value proposition, such as offering clients a set of multiple indices, support for socially responsible investing (SRI), tax optimization strategies, and other things that the direct indexing product can offer. They must then finalize the distribution model that will work best for them—fully digital, advisor-led, or hybrid.

Business capabilities: When launching direct indexing offerings, firms will need to evaluate their existing business capabilities and design a strategy to either upgrade or build newer capabilities. These include channel, investment planning, portfolio management, performance management, order management, trade processing, fees, and commissions. They should also look at client onboarding, market data, customer service, and product management functions or tools. The key components that firms must look at while introducing direct indexing products include the following:

• Investment planning: Advisors must be equipped with the requisite tools to capture clients’ value systems and beliefs across areas like social responsibility and environment and investment preferences. They can construct a personalized index based on indices that align with clients’ preferences and investment goals. 
• Portfolio management:
  • Advisors must monitor the personalized index on an ongoing basis, rebalance the portfolio to manage the threshold drifts, and optimize taxes.
  • They must also track portfolio performance against a personalized index. The portfolio rebalancer must automatically identify deviations, if any, from the index, trigger the rebalancing algorithm when the deviation exceeds predefined thresholds, and realign the portfolio with the personalized index by setting off buy or sell orders as appropriate.
  • Advisors must send consolidated performance reports to their clients at regular intervals.
  • They must identify individual security holdings in order to harvest tax-loss and offset capital gains. They do so by considering parameters such as clients’ value systems, investment preferences, tax profiles, portfolio holdings, tax lots, and market data. They must be equipped with the ability to configure business rules and threshold values to enhance the insights generated by the automated tax optimizer algorithm. They must also have the tools to review orders generated by the tax optimizer algorithm before they are executed.

Client journeys: The delivery model—fully digital, advisor-led, or hybrid, as well as the overall product strategy—will influence the client journeys for individual firms. Unlike other investment products, direct indexing offerings enable customization to match client-specific goals and preferences. This will impact the customer journey in the advisor-led and hybrid models, which in turn need to be factored in while defining the approach for launching direct indexing products.

While introducing a direct indexing offering into the client portfolio, an advisor must:

• Capture the client’s goals, investment preferences, values, and existing portfolio as part of the planning process
• Provide a set of reference indices for clients to choose from while collaborating with them to design a personalized index. This is primarily done by excluding individual securities from the reference index or modifying the weightage of certain securities.
• Obtain client sign-off on the personalized index.
• Construct a direct indexing portfolio based on the personalized index 
• Ensure efficient portfolio management through continuous monitoring

To provide direct indexing offerings on a fully digital model, firms must:

• Build best-in-class, intuitive mobile apps that offer a frictionless journey from initial investment planning phases to ongoing investment management. 
• Design mobile apps with features like digital assistants, personalized videos, visually rich client reporting, and educational content to further improve customer experiences

Technology platform: Firms must decide on the requisite technology platform based on the direct indexing product strategy and business capabilities. They should also assess if they should build an entirely new technology platform or upgrade their existing one. If they want to build a new platform, they can either develop it in-house or use a third-party platform. Costs and the time taken to launch the platform are key to this decision.

Alternatively, firms can leverage their larger ecosystem and partner with fintechs to use their platform to offer a direct indexing product. Another option is to partner with business solution providers and offer their direct indexing products, which will greatly cut time to market and accelerate the launch of those solutions.

How TCS can help

Direct indexing is not just another investment product.

It is an offering that will allow firms to elevate customer satisfaction levels by enriching the overall investment experience. Thanks to more than three decades of experience in the global wealth management industry, TCS offers end-to-end services that enables its customers to build direct indexing capabilities (see Figure 1).

TCS has built accelerators in key areas such as product management, which offers insights on what clients need in a direct indexing product. TCS also helps wealth management firms quickly select appropriate technology platforms by offering them the ability to run proofs of concepts and to connect with industry alliances. 

Figure 1: From conceptualization to implementation and beyond

Customers want hyper-personalized portfolios. Tax-efficient investment strategies will only increase demand for this product. Firms that accelerate their direct indexing journey stand to benefit from the advantage that comes from launching a unique, value-driven product in the market.