Taxes and ESG on Your Mind? Consider Direct Indexing

If investors prioritize tax loss harvesting and ESG investing, then they may want to consider direct indexing. It’s a technology slated for exponential growth in the coming years.

Cerulli Associates released a report late last year, The Case for Direct Indexing: Differentiation in a Competitive Marketplace, that highlighted the expansive growth that direct indexing is expected to see in the near-term horizon. Tailoring a portfolio that directly matches an investor’s goals gives the strategy a degree of flexibility. This is as opposed to investing in a fund that passively tracks an index.

Ironically, the report noted that not many investors are keen on direct indexing just yet. According to the report, just 14% of financial advisors know of and are currently recommending it to their clients.

“As advisors universally adopt fee-based models and financial planning, the line between business models is blurring, making differentiation challenging. Many wealth managers are looking to the tax management and customization features of direct indexing to create a personalized client experience,” said Tom O’Shea, Director at Cerulli, in a press release referencing a Cerulli report that says the methodology will reach more than $800 billion in assets by 2026. “Given investors’ desire to exercise more control over their portfolios, we believe that direct indexing will continue on its current growth trajectory for years to come.”

Tax Loss Harvesting and ESG

Tax loss harvesting, the strategy of selling off assets that have fallen in value to accumulate losses to offset income, can be done at the fund level. Direct indexing takes this to another level.

It allows the investor to sell off individual assets in the underperforming fund. For example, they can sell off individual stocks that constitute an index, offering a higher degree of flexibility.

That also applies in the case of choosing ESG investments. The investor can opt to choose their own holdings. This might be preferable to picking a fund that incorporates holdings based on ESG principles.

Because they own the actual stock versus a fund, investors can exercise their right to engage in shareholder activism. Investors essentially have control in picking the stocks/holdings that closely align with their ESG values.

Tax loss harvesting and tailor-made ESG are just two of the advantages the strategy offers. Once again, this speaks to the added flexibility of the methodology. That could add to its growth, as its usage increases in the capital markets.

“As direct indexing becomes more mainstream, Cerulli expects that assets will grow at an annualized rate of 12.3% over the next five years, faster than ETFs, mutual funds, or retail separate accounts. Cerulli also expects direct indexing to make up 33% of the retail separate account market by 2026,” the aforementioned press release noted.

For more news, information, and analysis, visit the Direct Indexing Channel.