Parametric: How Can Advisors Use Direct Indexing to Deepen Client Relationships?

(Thomas Lee, Co-President + CIO, Parametric) With more than 30 years of experience, more than 50,000 accounts, and a wide range of solutions, we believe Parametric is in a strong position in the growing direct indexing space. Here's how you may be able to help get your clients ahead with customized investing. 

At Parametric, we’re big fans of investment advisors. We’ve seen high-quality advisors make crucial differences in investors’ financial lives over and over again. When we think about how to build and manage investment portfolios for our wealth management clients, we’re almost always thinking of the construct of long-term advisor-client relationships.

Our direct indexing offerings in equity and fixed income exemplify our advisor focus especially well. We originally built our first direct indexing solution in 1992, in response to an advisor’s wish for an equity index-like outcome with enhanced tax efficiency. Today our advisor partners use our flagship direct indexing offering—customized, broad-market separately managed accounts (SMAs)—to connect with clients on big topics like active versus passive management; environmental, social, and governance (ESG) guidelines; charitable giving; and tax-aware portfolio transitions. While basic tax efficiency is still a powerful and compelling potential benefits of direct indexing 30 years later, advisors now seek to connect more deeply with their clients. Here are four areas of particular value.

An optimal active/passive private wealth portfolio often includes direct indexing 

All advisors must explicitly or implicitly take a position on allocating to active or passive strategies in public market investing. While some allocate 100% of their clients’ assets to one choice or the other, many carefully consider market efficiency, manager skill, and fees and taxes, leading them to incorporate both investing styles. The customization inherent in a direct indexing solution creates a richer active/passive discussion since accessing broad market exposure or beta in a custom SMA can add tax efficiency, ease of portfolio transitioning, and custom ESG guidelines to the analysis. 

Most portfolios end up with allocations to both active and passive strategies. Advisors and clients embrace direct indexing to improve the tax and fee efficiency of the overall portfolio. The best way to build a combined active/passive allocation while considering both fees and taxes is one of Parametric’s most frequently asked research questions. 

Take control of your passive investments

Capital loss harvesting has become increasingly popular in the lexicon of investment advice in the United States. Loss harvesting means selling a security or basket of securities at a loss and buying securities of a similar risk-return profile. These realized losses can be used to offset realized capital gains in current or future tax years. As a result, taxes are deferred or avoided, and clients’ after-tax wealth outcome is improved. Many investors and advisors do loss harvesting on an ad hoc basis, often near the end of the tax year. However, advisors who embrace the full power of direct indexing know that valuable tax management extends far beyond year-end loss harvesting.

Direct indexing can and should incorporate careful, risk-controlled loss harvesting all year round. However, the flexibility of a custom SMA extends much further. Advisors can manage portfolios for greater tax efficiency at inception, giving clients control over how much they’ll pay to move their holdings from one strategy or structure to another. This was a favorite benefit of direct indexing among advisors responding to a 2022 Cerulli Associates survey. Also, charitable giving from a well-managed direct indexing portfolio can simultaneously reduce unrealized gains and improve portfolio risk control while accomplishing the desired charitable intent. Gifting appreciated securities to charity helps sidestep the capital gains tax that would normally be applied to stock sales.

Our research in the early 1990s demonstrated that taxes can be a bigger drag on long-term performance than fees or trading costs. That conclusion still holds true today. We’re pleased to support successful advisors as they engage with clients in this valuable conversation.

A client’s definition of responsible investing is the definition that matters

A big surprise for us from the recent Cerulli Associates survey was what some advisors had to say about responsible investing—another facet of portfolio management that’s only getting more attention by the day. Three responses stood out the most:

Demand for responsible investing is too low to make it a worthwhile offering.

Responsible investing is too political to discuss with clients.

The boundaries of responsible investing are unclear.

Clearly, ESG and responsible investing conversations can be tricky for many advisors, and they need more tools and education to support them. A custom broad-market SMA can be of significant help in advancing advisor-client conversations in this area. The flexibility to incorporate basic screens or restrictions can often be a powerful first step. Discussions of active ownership and proxy voting might create a sense of engagement and clarity, as does clear reporting on portfolio holdings and characteristics.  

Ultimately responsible investing isn’t exclusive to any one set of values. One investor who wants fossil-fuel producers out of their portfolio can use the same portfolio-construction methods as another investor who will only hold companies with practices that align with their faith. One investor who wants to see more women on corporate boards can submit a similar type of proxy vote to that of another investor who wants to see more people of color in management. No matter the client’s politics, religion, or priorities, direct indexing gives advisors a flexible way to align their financial goals with their values and principles.

Direct indexing isn’t just for equities

Higher interest rates have made fixed income an attractive asset class, with tax-equivalent yields reaching the 7% to 8% range depending on an investor's particular tax situation. Direct indexing in the fixed income space can be challenging, since it’s not often possible to own all the thousands of individual bonds that make up a fixed income index. Parametric works with advisors to develop an index-like solution in the form of a fixed income ladder portfolio. This structure involves equally weighting municipal, corporate, or Treasury bonds across a specified range that the investor or their advisor determines—for example,  a one- to five-year laddered portfolio. When a bond rolls off the ladder at the shortest rung, we typically reinvest the proceeds at the longest rung. This structure allows us to pursue more dependable return outcomes. 

A laddered fixed income portfolio may offer many of the same potential benefits as a direct-indexed equity portfolio. We can incorporate a full range of customizations: maturity range, credit quality, geography, values-based guidelines, and active tax management, for instance. These customization features help advisors tailor fixed income portfolios to meet their clients’ specific needs—another way to prove their worth to investors when active security selection is less of a concern.

The bottom line

The role of the investment advisor has evolved quite extensively over the past decade. While security selection and manager evaluation still play a role, successful advice means engaging in client conversations across many dimensions. Some of the most important dimensions are macro in nature: portfolio construction, taxes, and responsible investing, just to name a few. Conversations in these areas can lead to advice that makes a difference, and direct indexing can help.  

We at Parametric have always believed in questioning the status quo and exploring new ways to help advisors serve their clients. It’s just that kind of curiosity that led us to launch our first direct indexing account back in 1992. We’re here to share what we’ve learned over these many decades of experience.



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