Direct Indexing

Optimal’s ground-breaking Direct Indexing solutions enables nearly any investor (starting at $100k investment) to expand their investment arsenal beyond traditional “pooled investment” structures such as ETFs, mutual funds, Target Date Funds or Structured Products. Instead of ownership through a pooled intermediary, the investor directly holds the underlying securities that make up an index or outcome-based strategy.

Why Direct Indexing?

Direct Indexing offers investors three key benefits versus traditional pooled or packaged investment solutions:

Tax alpha has been estimated to add between 1% and 2% in additional after-tax returns for a typical US high-tax bracket investor. Direct Indexing gives the investor a choice around what stocks to hold and what to sell. This flexibility permits the investor to utilize well known tax- management practices.

Direct indexing makes it possible for an investor to fine-tune, or more broadly alter, the individual  constituents of an index or investment strategy.

For instance, SRI considerations have advanced to the top of many investors’ agendas. Through Direct Indexing, the investor can adapt an index based on specific, investor-determined environmental, social or governance policies.

In a nutshell, instead of buying an off-the-shelf ETF, or even an SRI-based ETF, Optimal can apply screens specified by the investor. We can also add individualized screens such as filtering out legacy holdings, or faith-based preferences such as Shariah compliance.

As another example, an endowment or family office may wish to exclude companies suffering from low scores on labor practices (e.g. as a result of child labor or human rights violations). SRI ETFs that are available to the investor are standardized to predefined policies and screening rules, and it is likely the investor would have no ETF option available that would be so specific to this labor-based exclusion.

Additionally, an investor could implement an exclusion to avoid adding to an existing position that the investor already holds elsewhere in their portfolio (a legacy position). Consider an investor wishing to add an allocation of S&P 500 stocks. As a result of long-held legacy positions, this investor holds several stocks not prudent to sell, due to the large embedded capital gain liability. These stocks could therefore be excluded from the SMA portfolio to avoid adding to the stock-specific risk of these holdings.

Again, investing directly in the stock portfolio offers solutions otherwise unavailable in an ETF.

The growth in the sophistication of ETFs has been driven by the growth of sophistication of the underlying indices. What began in 1993 as relatively simple S&P500-based equity ETF has now grown to include Target Date Funds, Thematic ETFs and Defined Outcome ETFs. All of those indices and strategies are now available for Direct Indexing and customization.

Direct Indexing can take any investment strategy far beyond simple customization screens, and be used to create bespoke and adaptive execution programs that are precisely tailored to the investor’s needs, such as a 20% loss-limited version of the S&P 500 Ex Low-Vol. Or, just use “optimized narrowing” to create an eighty stock version of a much broader index, or even an index that automatically and adaptively rebalances stocks and bonds to deliver a payout with a pre-specified floor and upside target instead of the blind time-based rebalancing of a Target Date Fund.

Delivered as SMAs, these fully bespoke strategies can be exhaustively designed and tested within our Direct Indexing design tool suite, in conjunction with investment advice from Optimal as needed. They can be built as a combination of equities, rules-based Factor or Thematic indices, and Treasuries combined with sophisticated optimization techniques (such as Risk Parity, Max Sharpe Ratio etc). These can replace quant strategies without requiring an in-house quant team or an expensive active manager and can be delivered to the investor in simple, transparent, long-only Separately Managed Accounts without any derivatives or margin requirements.

Optimal’s Modern Direct Indexing tools have made the creation of individualized implementations “push-button” easy for advisors and institutions wishing to exercise greater control over the index investment process without having to resort to expensive and opaque actively managed or derivatives-based solutions.