Applications of Direct Indexing

Transcript

Hi, I’m Brian Smith, co-head of the Eaton Vance Wealth Strategies Group. In this video, we will cover the applications of direct indexing.

Direct indexing is a customizable form of passive investing that delivers full transparency and control by building the exposure in a Separately Managed Account.

Instead of owning a fund, where you are commingling assets with other investors, clients directly own the individual securities within the index.

The Separately Managed Account structure can unlock powerful tools for tax management, such as ongoing tax loss harvesting, tax-efficient rebalancing and better control when making withdrawals. It also opens the door to customization – such as blending benchmarks, introducing factors and tilts, building around pre-existing risk, or incorporating preferences and values through screening.

This is passive investing with precision.

Once you have decided that Direct Indexing is a worthwhile investment solution, how do you go about incorporating it into your practice?

Direct indexing can be a Swiss army knife – there are so many different applications. Let’s review some of the ways we have seen advisors apply direct indexing to client portfolios:

We’ll start with using direct indexing as a core allocation.

Direct Indexing is an alternative way of incorporating beta to a client’s portfolio as frequently, clients are seeking beta in large-cap exposure. I’m sure no one would be surprised to hear that the S&P 500 is the most frequently requested benchmark.

We have seen incredible adoption of folks using Direct Indexing as the core of their portfolio which allows them to incorporate less tax efficient investments as satellites around it.

By having a tax-loss harvesting mandate as the centerpiece, it can reduce tax drag across the entire portfolio, acting as a loss generating engine to offset gains from active management, portfolio turnover, asset class rebalancing and withdrawals.

The second application would be the inverse, using direct indexing as a satellite to help make overall the portfolio more tax efficient.  Frequently, advisors already have a core mandate in place. They can use Direct Indexing in a different sleeve of the client’s asset allocation such as mid-cap, small-cap, developed international, or a specialty benchmark, acting as a satellite to that core.

So, next is using direct indexing as a tool for transitions.

One of the incredible features of direct indexing is the ability to fund in-kind, meaning that a client does not necessarily need to have cash on hand to get started. We can take on existing assets they already own and reshape them to look more like a selected benchmark. In fact, about 50% of our accounts are funded in this manner.

There are a number of different reasons that there could be “money in motion,” such as:

• Bringing on new clients
• Consolidating a client’s assets
• Terminating an underperforming manager
• Transitioning from a self-directed or rep-as-PM-investment approach or
• Taking over a practice.

The process of funding an account in-kind starts by running a transition analysis. This can be a great resource to use with clients that presents several outcomes and demonstrates the control they have when funding. One of the things that makes Eaton Vance and Parametric uniquely positioned is our ability to use the broad suite of tax-managed solutions to minimize tax frictions when transitioning portfolios.

Our next application is using direct indexing to manage concentration risk.

This is an extension of our last application as another common form of in-kind funding is when a client has significant exposure to a concentrated stock.

We can deploy a staged diversification strategy to spread tax friction over multiple years and also use the tax losses generated from the tax management overlay to speed up the rate at which we can take chips off the table.

A client can also provide parameters such as a capital gains budget or a timeframe in which they would like us to unwind the position.

When working with concentrated stock, you are in control of the liquidation plan; however, some exit events happen all at once. Given adequate time to prepare for such an event, investors can utilize direct indexing to reduce the eventual out-of-pocket tax cost from such a liquidity event.

The losses created from direct indexing can be used in the year they are generated but can also be accumulated and carried forward, enabling clients to build up a war chest of losses for the future. The last application we’ll cover today is customization.

Direct indexing gives a client complete control over their exposure.  That customization could come in a number of different formats.

• A client might be asking us to build a completion exposure or build around a preexisting risk. They may want to remove an individual ticker, industry or sector.

• Other clients may have preferences to incorporate values or personal preferences. This could be faith-based, environmental causes, social themes or governance.

• With help from third-party data providers, we offer a broad menu of screens to align with a client’s investment policy statement, risk rail targets, or personal values.

We hope this overview has demonstrated how direct indexing can be a dynamic and valuable tool to help solve critical problems for clients including tax mitigation, risk management, and reflecting client values in investment portfolios.