Direct Indexing: Custom Beta Strategies for Large Portfolios

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Key Takeaways

• Direct indexing gives investors ownership of the underlying securities, providing more tax benefits and customization than index funds and ETFs.
• This approach facilitates customization, allowing portfolios to align with investor beliefs, values and risk appetites — including ESG screening and thematic exposure.
• Technology and automation are key to controlling the complexity, scalability and reporting requirements of large direct indexing portfolios.
• Investors benefit from enhanced tax efficiency from continuous tax loss harvesting and optimized tax management, increasing portfolio returns.
• Financial advisors play a critical role in educating clients, curating personalized strategies, and behavioral coaching to keep investors on track.
• Though direct indexing provides numerous strategic advantages, thoughtful attention to implementation obstacles like cost basis monitoring and operational intricacy is crucial for success.

Direct indexing with custom beta strategies for large portfolios means picking each stock in an index to match personal needs and risk goals.

Lots of large investors apply it to optimize returns, reduce expenses and assist with taxes.

It’s great for large portfolios, allowing managers to adjust holdings to accommodate market changes and investor objectives.

To illustrate how it operates, the sections below decompose essential actions and practical applications.

Defining Direct Indexing

Direct indexing allows investors to select and directly hold each individual stock in a benchmark index, instead of simply holding shares in a pooled fund or ETF. This option is well suited for those seeking to escape one-size-fits-all investing and craft their own route with a separately managed account.

Because you own each stock outright, you can manage tax moves, asset choices, and even values-based screens, all within a single portfolio.

Direct indexing is taking off as technology makes it easier to monitor and rebalance hundreds of holdings at a time. With it, investors can sell stocks that dip below cost, buy similar but not identical stocks to circumvent the wash-sale rule, and harvest tax losses to offset gains or up to $3,000 of ordinary income.

The process, particularly if done daily or monthly, can contribute 1%–2% in after-tax returns, making it attractive to those with higher tax rates or longer time horizons.

Beyond ETFs

Direct indexing can be more tax efficient than passive ETFs. By selling stocks with losses and rapidly replacing them, investors can proactively manage their tax bill in ways ETFs cannot.

ETFs generally only pass on tax events when the fund sells holdings, which is less frequent and less flexible. Customization is a pull. If you want to avoid some industries or tilt toward others, direct indexing facilitates this.

Say a global investor doesn’t want oil stocks for environmental reasons or wants to overweight tech. Investors sidestep ETF constraints like hard sector weights, embedded capital gains, or forced exposure to every name in an index.

Instead, they are able to sidestep stocks they dislike or double down on themes that matter to them.

Portfolio Replication

Portfolio replication refers to purchasing a basket of stocks to replicate the returns of an index as closely as possible. The idea is to mimic the index but with direct ownership of the stocks.

Diversification remains paramount. Direct indexing platforms, for instance, frequently purchase sufficient stocks to replicate the risk and return of the selected benchmark, even if they don’t have every single stock.

It can be molded to various objectives. Some investors desire lower risk, others more growth, and the holdings can flex to fit these needs.

Technology manages thousands of trades, maintains tracking error at low levels, and enables investors to respond to tax or market shifts immediately.

Ownership Structure

Direct indexing is owning every stock yourself, not just in a fund. This architecture simplifies tax maneuvers and makes them more accurate.

It provides investors with a cleaner line of sight. They know precisely what they own and can act accordingly.

Direct ownership of stocks can transform risk and return. The investor may assume more tracking error, but receives more control.

Custom Beta Strategies

Custom beta strategies customize portfolio risk and return to match what each investor desires. Such strategies utilize direct indexing to construct portfolios tailored to specific requirements, as opposed to adhering to a conventional index fund.

Direct indexing became far more prevalent, growing to $546.7 billion in assets in 2023. By permitting selections around risk, tax, and investment themes, custom beta strategies allow investors to assume greater control, particularly those with sizable portfolios or unique tax requirements.

Investors can adjust their portfolios using custom beta strategies, including:

• Factor exposures (like value, size, quality, or momentum)
• ESG (Environmental, Social, Governance) preferences
• Thematic trends (such as green energy or tech innovation)
• Risk hedging techniques
• Tax management strategies (such as tax-loss harvesting or bond ladders)

By selecting the appropriate blend, investors are able to more closely match portfolios to their objectives, risk tolerances and values.

1. Factor Tilting

In this context, factor tilting refers to shifting the exposure of a portfolio to particular risk factors such as value, small size, or quality. This can help discover market mispricings and leverage them to obtain superior returns.

With direct indexing, investors can select stocks that align with specific factors, instead of simply tracking an index. For instance, a big portfolio can skew toward high momentum stocks or low voltage companies.

This allows investors to capture momentum or hedge downside. It provides opportunities for more effective diversification, as the combination of factors can reduce exposure to a single industry or sector.

2. ESG Integration

ESG integration incorporates environmental, social and governance considerations into the investment process. Most investors desire portfolios aligned with their values — whether that’s climate responsibility or ethical business.

Direct indexing simplifies the process of excluding companies that fall short on ESG criteria. Investors can construct a custom ESG-focused index, selecting firms based on carbon footprints, board diversity or labor policies.

The need for ESG investing is transcending globally. This pivot is altering the face of portfolios and can potentially increase long-term returns, as sustainable businesses tend to exhibit stable growth and reduced risk.

Because ESG investing is not one size fits all, direct indexing is a natural fit for customizing these decisions.

3. Thematic Exposure

Thematic exposure refers to putting your money in trends or sectors that appear poised to expand, such as clean energy, technology, healthcare, or robotics. With direct indexing, you can pick stocks in a theme instead of simply owning the broad market.

That way, they can either pursue growth in areas they’re believers in, or diversify risk by owning global stocks among several themes. For instance, constructing a custom index around green infrastructure or digital health allows investors to align individual passions and secular trends.

Thematic strategies are customizable—investors determine what themes are most important and how much exposure to provide.

4. Risk Hedging

Risk hedging is reducing the likelihood of big losses. Direct indexing allows you to combine stocks or strategies that help protect against market volatility, such as holding defensive stocks or using options.

A few sophisticated investors employ bond ladders to hedge interest rate risk, purchasing bonds with staggered expiration dates. Aligning these hedges with overall goals is key.

Adding hedges may boost risk-adjusted returns over time. Hedging is most appropriate for large portfolios or unique risks.

5. Tax Overlay

Tax overlay looks to increase after-tax returns. Direct indexing finds tax savings by selling losing stocks to offset gains—known as tax-loss harvesting.

Daily scans detect these opportunities, which can contribute 1-2 percent in after-tax returns. Designing a bond ladder within a custom index can assist in tax planning over time as well.

Continued tax drag review keeps investors more of what they make.

Strategic Advantages

Direct indexing presents a number of strategic benefits for sizable portfolios, providing greater control, tax efficiency, and transparency than standard index funds. Investors can more closely match strategies to their individual circumstances, and the method tends to deliver superior after-tax outcomes, particularly for those with higher tax rates or more complicated portfolios.

Key strategic advantages of direct indexing include enhanced tax alpha through frequent tax-loss harvesting, greater personalization for specific goals and values, increased transparency with direct security ownership, flexibility in managing concentrated positions and legacy assets, and improved alignment with long-term financial objectives.

Tax Alpha

Direct indexing is great at increasing tax alpha. It allows investors to harvest losses — selling stocks that have fallen, and using those losses to counter gains elsewhere in their portfolio. This is unlike conventional index funds, where this ability is restricted.

Tax-loss harvesting, on a daily or monthly basis, can generate 1%–2% in after-tax excess returns. The frequency of these scans matters—more frequent scans mean more opportunities to uncover losses, providing investors with a strategic advantage in minimizing tax obligations and maximizing return retention.

Personalization

Direct indexing brings personalization to the forefront of portfolio management. For investors with unique objectives — for example, those who want to avoid certain sectors, or brands and values-aligned portfolios — they can create bespoke indexes. This can be particularly helpful for high net worth individuals or those with specialized long-term planning.

Custom portfolios facilitate investor engagement. When a portfolio represents personal values or social convictions, involvement and enjoyment increase. This customization paves the way for superior outcomes, as portfolios are crafted to align with each investor’s objectives, not a broad market benchmark.

Direct indexing benefits investors with legacy or concentrated positions, allowing them to control existing holdings without causing big tax events.

Transparency

Direct indexing provides a more transparent view into ownership and performance. Investors see every stock in their portfolio and track results — unlike with pooled funds, where holdings and trades are more obscure.

Direct ownership provides complete control and visibility. With transparent reporting and continuous analytics, investors have a precise understanding of their position. This aids in establishing trust and maintaining strategies with target objectives.

Transparency is key for those who want to know how their money ticks, particularly when you’re dealing with large, complex portfolios.

Implementation Hurdles

Direct indexing custom beta strategies for big portfolios present implementation challenges. These implementation hurdles require diligent attention to ensure the strategy provides on its tax and personalization advantages. Below is a checklist that outlines common hurdles:

• Cost basis tracking for each stock
• Scalability of managing thousands of holdings
• High operational demands for monitoring and trading
• Complexity of direct ownership versus pooled funds
• Need for advanced technology solutions
• Ongoing tax-loss harvesting and related recordkeeping

Cost Basis

Cost basis is the original value of a security for tax purposes. With direct indexing, owners hold every stock in a portfolio, so the cost basis for every holding must be individually monitored.

Tracking cost basis for thousands of individual stocks can become complex, particularly with active trading and tax-loss harvesting. If the system is not robust, errors can creep in, giving you tax reporting issues that could impact the investor’s returns.

Getting cost basis right helps boost tax efficiency. Investors in high tax brackets, or with large capital gains, benefit most from precise tracking—this allows them to optimize tax-loss harvesting, which can add 1-2% or more to after-tax returns.

Technology solutions are a big part of this. Tools that automate cost basis tracking and make reporting easier are crucial for staying both sane and precise.

Scalability

Direct indexing is hard to scale because handling hundreds or thousands of stocks is resource-intensive. For instance, the largest broad-market US equity index has roughly 3,400 stocks, but widely followed bond indexes can have tens of thousands of individual issues.

Technology assists by implementing automated trading, monitoring, and tax-loss harvesting. If a portfolio is scanned daily for losses, it can still provide tax alpha, even in quiet markets.

Operational efficiency, such as system integration and process automation, is critical to keep these large portfolios humming. A dynamic benchmark structure that considers the fractured bond market can assist. This allows portfolios to refresh rapidly and without manual supervision.

Complexity

Direct indexing is more complicated than purchasing a mutual fund or ETF. Because each investor holds shares of individual securities, too, the method requires advanced technology and expertise.

This complicates matters as compared to pooled vehicles. We need experts to stay on top of market shifts, corporate actions, and tax regulations.

Technology platforms with daily monitoring and trading functions are becoming the norm. Being aware of where each stock is trading is prudent because every holding impacts risk and return.

Financial advisors contribute greatly by walking clients through decisions, assisting them to comprehend the risks, and ensuring portfolios remain in sync with their objectives.

The Technology Stack

Direct indexing’s core tech stack combines analytics, automation, and reporting tools to enable custom beta strategies–making personalized indexing feasible for big and little portfolios. These platforms now allow investors to construct completion portfolios, execute tax-managed transitions, and apply rules-based strategies.

Tech upgrades have opened direct indexing to more people, with some platforms setting entry points as low as $5,000, all while enabling hands-on stock picking. Customization and flexibility are the magic bullets, and we believe the technology will power solid direct indexing asset growth.

Analytics

Analytics in direct indexing refers to evidence-based portfolio selection, risk monitoring and rebalancing. These tools allow portfolio managers to disaggregate an index, monitor the performance of individual stocks and identify areas where a portfolio may drift from its target.

With sophisticated analytics, investors and advisors can conduct “what if” analyses, backtest strategies, and benchmark bespoke portfolios against global indices such as the S&P 500 or Russell 2000. Analytics can highlight where to adjust holdings for improved risk or tax efficiency.

This data-centric philosophy is at the heart of optimizing each portfolio’s construction and management — particularly when investors desire a blend of index tracking and personal touches such as ESG filters or sector tilts.

It’s easier to measure performance against benchmarks. They help demonstrate if a portfolio is keeping pace with, outperforming, or underperforming its benchmark index. These insights drive continuous optimizations and allow directors to establish clear, achievable expectations for customers.

Automation

Automation introduces both velocity and precision to direct indexing. Things that used to require hours—such as purchasing hundreds of stocks in order to mimic an index—now execute with a few clicks.

Automated workflows reduce overhead. They perform automatic rebalancing, cash flows, and tax-loss harvesting with no manual intervention, making these strategies accessible to a much broader set of investors.

For instance, automation can identify tax-loss harvesting opportunities on a daily or even hourly basis, reducing taxable gains. It’s critical for tax-managed transitions.

When migrating from an existing portfolio to a direct indexing solution, algorithms can choose the optimal method and timing to offload legacy holdings, trying to minimize tax liabilities. Seamless portfolio transitions — automated systems track cost basis, wash sale rules, and other tax factors in real time, resulting in fewer errors and smoother transitions.

Reporting

Reporting provides both managers and clients clear visibility into what is occurring in a portfolio. It’s not just about end-of-year summaries; real-time dashboards display holdings, performance, and tax savings as they occur.

Thorough but easy to understand reports establish credibility. Investors get to view custom beta strategies in action, and know why portfolios shift. This openness is crucial for investors seeking to understand how their investments align with individual or organizational priorities.

Real-time reporting aids in catching risks early, identifying outliers, and reporting results to stakeholders—be it individuals, families, or major institutions. Reporting assists advisors in describing strategies in straightforward language, allowing clients to be informed and involved.

The Advisor’s Role

Advisors are integral to leading clients through direct indexing, particularly as portfolios become more intricate and objectives become more precise. They span from demystifying strategies and risk to tailoring portfolios to unique client needs. Advisors help manage emotions, coach clients through difficult market swings, and keep investment plans on course.

Client Education

Educating clients on direct indexing shows them the advantages. Clients discover how it allows them to select the stocks in their portfolios and not merely hold a share of a fund. They understand how direct indexing can aid with taxes, such as harvesting losses to reduce their liabilities.

Education extends beyond the fundamentals. Advisors share guides, webinars, or tools so clients know how direct indexing works in various markets. When clients understand how bespoke beta strategies are constructed, they’re more apt to have faith in the method. For instance, an advisor can demonstrate how a portfolio can be constructed around a client’s current stock holdings or why tracking error may stray from the index.

Education is not an event. Markets evolve, policies shift and platforms launch. Continued education helps clients stay informed and empowered to make decisions as their requirements evolve.

Behavioral Coaching

Behavioral coaching is assisting clients adhere to their strategy, even when markets rattle. This coaching matters because humans tend to act out of fear or greed—selling when stocks dip or running after the shiny new thing.

Advisors intervene by instead displaying to clients how to think in terms of their long-term objectives, not what’s going on in the headlines. Easy check-ins, straightforward progress reports, and candid conversations about risk all assist in putting emotion in its place.

For example, if a client’s portfolio takes a dip, an advisor can provide context about market cycles and how their direct indexing approach is designed for the long-term. This type of coaching fosters trust. When clients observe that their advisor is calm and has a strategy, they tend to stick with it and achieve their objectives.

Strategy Curation

Curation strategies are all about creating portfolios that resonate with each client. Advisors examine what clients already have—large stock positions or grandfathered assets from their career—and construct around those with direct indexing. They ensure portfolios align with client objectives, risk constraints, and even values.

Direct indexing assists here by allowing advisors to select stocks to prevent overlap, reduce risk, or align with a client’s values. Advisors may employ heuristics, such as Smart Beta, to identify stocks with specific characteristics. They watch taxes, selling losers to offset gains and help clients retain more of what they make.

It’s a manual labor position, but it can generate improved client returns for sizable or specialized portfolios.

Conclusion

Direct indexing offers large portfolios a method to customize risk and returns. With custom beta, people can select stocks to align with objectives or beliefs. No need to settle for an index. So humans use tech to sift data and trade quick. Advisors assist in establishing the plan and monitoring outcomes. Some companies are expensive or require improved tooling, but the industry marches on. More investors seek control and transparency of decision-making. Direct indexing for those seeking more than your average fund. To maximize it, consult an advisor, evaluate alternatives, and see if it works for you. Seek opportunities to make your portfolio punch above its weight and tailored to your objective.

Frequently Asked Questions

What is direct indexing?

Direct indexing is an investment strategy that involves owning the actual stocks of an index. For example, it lets you personalize your portfolio and optimize taxes beyond what typical index funds can accomplish.

How does direct indexing support custom beta strategies?

Direct indexing allows investors to customize portfolio exposures to risk factors like sector or region. This flexibility allows for custom beta strategies that serve personal objectives and risk tolerances.

What are the main benefits of direct indexing for large portfolios?

Direct indexing for large portfolios can provide more tax efficiency, tailored exposures and even the capability to avoid certain stocks or sectors.

What challenges are involved in implementing direct indexing?

Direct indexing is a complicated practice to execute well. It demands sophisticated technology, painstaking transaction cost management and frequent portfolio rebalancing to keep pace with its investment objectives.

What technology is needed for direct indexing?

Direct indexing depends on portfolio management platforms that automate trading, tax-loss harvesting, and performance tracking. These tools keep you sane.

How do financial advisors add value with direct indexing?

Advisors assist investors in creating bespoke strategies, managing intricate execution, and delivering continuous oversight. Their skill keeps the portfolio on track with the investor’s goals.

Is direct indexing suitable for all investors?

Direct indexing is best for larger portfolios that want customization and tax benefits. It can be less cost efficient for small portfolios given trading and management costs.