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Direct Indexing: Potential Revenue Stream, Hiring Incentive for RIAs

By Sam Del Rowe, Financial Advisor IQ

As seen on financialadvisoriq.com

Many registered investment advisors are not proactively offering direct indexing to clients, but it could be a potential new source of revenue and may be an incentive when trying to attract advisor recruits.

Direct indexing gives clients broad exposure to an asset class, such as large-capitalized equities. But rather than buy a mutual fund or exchange-traded fund, investors own the individual stocks that comprise an index. The customization comes in when advisors tweak which index components they buy — or don’t buy — and in what proportions.

Reverse Engineering

Direct indexing is an opportunity to charge higher fees and could be used as a recruitment tool, according to Barrett Ayers, president at Adhesion Wealth, a Charlotte, North Carolina-based company that provides technology solutions to RIA firms. Adhesion, itself an RIA firm, is a subsidiary of Vestmark.

Direct indexing can be “a whole new revenue stream for advisors if they really understand and start to think about their operational plan to deploy it,” according to Ayers.

“Imagine managing a portfolio that was tax-neutral at the end of the year and had their own customized screening capabilities on it. Absolutely that demands a higher fee,” Ayers said.

“Switching out a passive index-based mutual fund and moving to something that was far more affordable with a direct index and maybe saving your client five to ten basis points. Absolutely the advisor should think about increasing their fees,” he added. Having direct indexing capabilities can help attract advisors who have access to that strategy in their current firms, according to Ayers.

“Advisors who are thinking about recruiting and bringing on new advisors, those roll-up firms or firms that want to think about M&A, this is an incredibly important part of their strategic roadmap,” he said.

“Imagine a breakaway advisor who you want to recruit over to your firm. All these holdings that were managed over at the wirehouse could be absorbed into a direct index,” he added.

Advisors must be clear about how they are going to deploy direct indexing if they decide to offer it to clients, according to Ayers. “Advisors need to take a step back and reverse engineer exactly what it is that they’re trying to do,” he said.

Building a portfolio “that blends active and passive together in a core satellite strategy” is the most common use case for direct indexing, according to Ayers.

“Advisors are looking to blend active and passive, and it no longer makes sense to do that with a large S&P 500 mutual fund or one ETF in the middle of a larger portfolio,” he said. Advisors need to consider “how they are going to manage five separate sleeves: one of them is now this direct index but the other four are going to be things like All Cap Core, International, Large Cap Growth and some other asset class,” according to Ayers.

Advisors should be asking themselves: “How am I going to manage a client who has unique allocations to those five components, one of which is now my direct index?” Ayers said. “That is the operational hurdle that most people should be focusing on. They now have tools all over the place to get the direct index — how are they going to manage that module inside of a larger portfolio allocation?”

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