Direct indexing can be a powerful solution for investors looking for portfolio customization and tax alpha. Merrie Zhang, CFA, Head of Direct Indexing Client Portfolio Management at Goldman Sachs Asset Management, says direct indexing provides solutions for a range of investor challenges and can be used as a key strategy at the core of investment portfolios. Zhang shares with us how direct indexing works, the potential benefits of it, as well as best practices on selecting a provider.
Question: What is the current industry landscape for direct indexing? Has it been growing in popularity?
Merrie Zhang: Direct indexing has grown significantly over the past few years as clients are seeking more customized solutions to help them address their specific investment goals. Currently there’s nearly $800 billion in direct indexing assets across the industry, which is up more than 5x from a few years ago [1]. We see that more and more financial advisors are incorporating direct indexing into their clients’ investment portfolios.
There’s also been a flurry of industry-wide acquisition activity as many asset managers have acquired direct indexing managers or launched their own direct indexing strategies. We believe it’s because these managers are looking to participate in this industry-wide shift towards more customized investing.
There’s been a lot of buzz around the growth of direct indexing, but we think this is just the beginning. As more clients understand the potential benefits of direct indexing, we anticipate continued increased demand and growth in this space. When we meet with advisors, we’re still spending a lot of time educating on direct indexing, how it works and the potential benefits of it. We see that once advisors understand the power of direct indexing, many are starting to transition their practice to incorporate direct indexing as their clients’ core equity exposure. We believe direct indexing represents the future of asset management and are very excited about the continued opportunities ahead.
Question: What are the main goals of a direct indexing portfolio?
Zhang: Direct indexing strategies typically have three main goals. The first is to deliver investment performance in line with the broad equity market. If equity markets are up 10%, direct indexing portfolios also aim to be up 10%. The second goal is to provide a tax benefit by tax loss harvesting throughout the year, so that investors can use the harvested realized capital losses to offset realized capital gains, providing the investor with potential tax savings. And the third goal is to provide additional client-specific customizations such as for risk management or values alignment. An example here would be helping clients tax efficiently diversify out of concentrated stock in a way that aligns with their specific risk and tax preferences.
Question: Can you walk us through an example of how direct indexing works?
Zhang: With direct indexing, we invest directly in individual companies through a separately managed account (SMA). If a client funds the account with cash, we invest the cash by purchasing a few hundred individual companies. By owning these individual companies, we’ve built a diversified equity portfolio that aims to perform in line with the broad equity market – the first goal we discussed earlier. Direct ownership of these companies enables us to provide greater customization to client needs, such as tax and risk management or values alignment.
Direct indexing is often used for the range of potential tax benefits it can provide. We review all of our direct indexing accounts on a daily basis and look for opportunities to tax loss harvest on the individual names held in the accounts. As a simplified example, if you own ‘company A’ in your direct indexing portfolio and ‘company A’ falls to a loss from the price we bought it at, we may rebalance the portfolio to sell ‘company A’ and perhaps buy ‘company B.’ The goal of this trade is to lock in and harvest a realized capital loss for the client while ensuring the portfolio continues to maintain broad equity market exposure. In practice, our rebalancing is not a one-for-one pairs trade; rather, it involves selling a group, or basket, of stocks, and buying a basket of replacement stocks back. Clients may have realized capital gains from many different sources such as gains from mutual fund distributions or selling appreciated stock. Whatever the client’s source of realized capital gains may be, tax loss harvesting through direct indexing can offer potential tax savings.
Question: ETFs have historically been a common investment vehicle to get broad equity market exposure. Why should clients consider direct indexing over an ETF?
Zhang: One of the main reasons a client may prefer direct indexing over an ETF to get equity market exposure is the opportunity for greater tax benefit. With an ETF, the client owns one ticker that represents the market, so the client can only tax loss harvest when the entire equity market is down. With direct indexing, since the client directly owns the individual stocks, there is potential to provide tax benefit across all market environments. In fact, across every calendar year, regardless of whether the equity markets are up, down or flat, the majority of names in the S&P 500 have fallen to a loss at some point in every year. With direct indexing, since the client owns the individual companies, we can tax loss harvest in markets where you cannot with an ETF.
Clients may also want to customize their market exposure. For example, let’s say you have a client that works at a mega-cap Tech company and receives a lot of company stock as part of their compensation plan. If that client invests in a broad market ETF, they would likely be increasing their exposure to that Tech stock. With direct indexing, we can build a portfolio around a client’s existing exposures such as by screening out the Tech stock so the direct indexing portfolio does not add to their concentration risk. This can provide the client with a more diversified overall portfolio.
Question: With tens of thousands of direct indexing accounts, each one customized and optimized on a daily basis, how do you manage scale as the asset manager? Does technology play a big role?
Zhang: Yes, technology plays an absolutely critical role. We are extremely focused on investing in technology to continue to scale our business. Scale is so critical to direct indexing strategies because every individual direct indexing account is unique. Every account can have a unique set of positions and cost basis. If client A invests today and client B invested a week ago, they would have different purchase prices, different cost basis for their portfolio holdings. When we rebalance client A’s portfolio, it may have a very different set of trades than client B’s portfolio.
At Goldman Sachs Asset Management, we have focused on investing in technology and scale to deliver optimal client outcomes across the nearly 50,000 accounts that we manage. We run all accounts through our optimization algorithm on a daily basis to determine which accounts should be traded and what is the most optimal trade for each client. Our portfolio management team provides oversight on the process and continually looks for opportunities to enhance our process to aim to continue to deliver best in class results for our clients.
Question: How are advisors incorporating direct indexing in their clients’ broader investment portfolios?
Zhang: Clients typically use direct indexing as their core equity exposure, and, typically, for their U.S. equity exposure. For U.S. equity market exposure, more and more advisors are gravitating towards passive exposure and many have started using direct indexing where they can achieve the market return enhanced with potential tax benefit.
By using direct indexing as their core equity exposure, the client can use the losses we harvest to potentially offset realized capital gains from other parts of their portfolio. These gains may be from the portions that are actively managed or their alternatives exposure. They can also use the losses we harvest to potentially offset realized capital gains as they’re rebalancing to their target asset allocation throughout the year. The end result is a more tax efficient overall investment portfolio that allows them to potentially keep more of what they earn. At the end of the day, it’s really what you keep that counts.
Question: What are some of the common client use cases that direct indexing can be used for?
Zhang: There are so many different use cases for direct indexing. Direct indexing can be used to help business owners plan for liquidity events. Because realized capital losses don’t expire at the federal level, clients that are expecting future realized capital gains such as from selling a business can use direct indexing to accumulate, or build up a “war chest” of, realized capital losses to help offset future gains. It can be a great wealth planning tool.
Another key use case is using direct indexing to help diversify out of concentrated stock. Equity markets have appreciated so much over the past few decades – U.S. stocks are up over 200% in the last 10 years. And the ‘Magnificent 7’ is up over 2000% in the same timeframe. There are many clients with concentrated and appreciated stock portfolios; there’s about $9 trillion of individual stocks sitting in brokerage accounts [1]. Direct indexing can be a powerful tool to provide clients with tax efficient diversification out of these concentrated positions; the tax loss harvesting from the direct indexing portfolio can be used to offset realized gains from selling down concentrated stock. We frequently partner with advisors to design custom transition plans that help clients accomplish their diversification objectives.
Question: How do you select the right direct indexing provider?
Zhang: That’s a really important question. When you’re evaluating direct indexing providers, we believe the key things to look for are, first, the investment performance track record. And second, the advisor partnership and client service experience.
With any investment strategy, investment performance is of utmost importance. With direct indexing strategies, investment performance is measured based on pre-tax returns and after-tax returns. These strategies should perform in line with the market pre-tax to showcase that they’ve delivered strong risk management. After-tax is where these strategies should outperform or generate what’s commonly called tax alpha. When evaluating a direct indexing provider, it’s important to look at how they deliver on both of these goals. With so many newer providers, it’s also very important to look at the length of their performance track record to see how consistently they’ve been able to deliver on their performance objectives across various market cycles.
Additionally, the advisor partnership and client service are also critical since direct indexing portfolios are customized solutions and are typically used for an advisor’s higher net worth clients. Each client’s situation is unique. It’s important to look at how much experience the manager has in partnering with advisors to design thoughtful solutions for clients.
At Goldman Sachs Asset Management, we’re focused on delivering industry leading investment performance – greater tax alpha and superior risk management. We have a proven track record of over 25 years, currently manage nearly $200 billion in direct indexing assets, and have built an investment platform that’s focused on designing bespoke solutions for ultra-high and high net worth clients.
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General Disclosures
[1] Source: Cerulli Associates
Risk Considerations
Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Different investment styles (e.g., “growth” and “value”) tend to shift in and out of favor, and, at times, the strategy may underperform other strategies that invest in similar asset classes. The market capitalization of a company may also involve greater risks (e.g. “small” or “mid” cap companies) than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements, in addition to lower liquidity.
Tax Considerations
The strategy may result in adverse tax consequences for the client including, but not limited to, wash sales. Under the wash sale rules, a loss from the sale of shares of stock or securities is disallowed if the taxpayer acquires, or enters into a contract or option to acquire, “substantially identical” stock or securities within 30 days before or after the sale. GSAM may intentionally engage in wash sales when it believes that the trades are beneficial for the client to do so. In addition, GSAM may be unable to avoid wash sales in certain circumstances given uncertainty around the “substantially identical” standard. For example, there is considerable uncertainty around applying a “substantial overlap test” to evaluate whether certain mutual funds or equity baskets are “substantially identical” to each other, the treatment of unrelated issuers engaged in a merger or acquisition, the treatment of convertible preferred equity and/or the treatment of contracts or options to acquire stock or securities. In addition, data used for portfolio management may be incomplete, will be limited to information regarding the strategy account, and will not include information regarding positions held or transactions executed outside of the strategy account including other accounts managed by Goldman Sachs or its affiliates. Transactions in two or more accounts that are deemed to be related under the relevant tax rules and regulations (“related accounts”) may be subject to the wash sales rules that disallow or defer the recognition of losses. GSAM will generally only consider positions and transactions in your Account on a standalone basis when executing the strategy. If you instruct us to treat certain accounts as related for tax purposes, GSAM may take this instruction into account in its investment management process in order to reduce wash sales across the related accounts. GSAM relies on the information provided by clients or their advisers with respect to a client’s related accounts in order to limit the likelihood of wash sales from trades executed in the strategy account and related accounts. As a result, portfolio management decisions may be based on incomplete information. To the extent that one or more accounts are managed as related for tax purposes, GSAM may limit trading across those accounts to avoid wash sales which may result in less loss harvesting for the accounts. The US tax code allows capital losses to be carried forward indefinitely until portfolio is bequeathed. The cost basis of a tax loss harvesting portfolio is driven down due to the realization of capital losses, creating a contingent tax liability. For investors who will eventually bequest their tax loss harvesting portfolio to charity or to their heirs upon death, taxes on the unrealized gains are generally avoided. However, if the tax loss harvesting portfolio is liquidated, the investor will pay taxes on the realized gains upon liquidation.
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