Isn't it Difficult to Explain and Process a Direct Indexing Portfolio?

Part 4 of  "Absolutely, Positively, Yes! Direct Indexes Make Sense for Investors Worth Less Than $1MM and Over $5MM"

This is a continuation of our responses to Jerry Michael's and Brent Sullivan's conversation on LinkedIn.

Objection: Explaining and processing the portfolio

Jerry’s Response: As noted above, the management of direct indexes can be automated, so "processing" the portfolio should be no harder with direct indexes than with ETFs. On the other hand, explaining what's going on may, indeed, take more time. Having more securities in an account does slightly increase the frequency of client calls. For large clients this is desirable. For smaller clients, maybe less so. And this is, by far, the main reason we see firms creating a size cutoff for direct indexing.

Comment from Brent: "The "explaining" part usually has to do with 1) the large number of line items on a tax return, 2) the large number of transitioning assets, and 3) what tracking error even is. What I'm hearing, understandably, is that clients don't care to understand this stuff (who can blame them?), but are concerned when they're paying more for a direct index SMA and getting hit by underperformance, versus an easy-to-understand ETF."

{This may be a bit much, but additional comments from us in response to Brent's additional comments: 1) as folks move to online statements and online tax filing, the "number of line items" concern basically goes away. 2) The number of transitioning assets is not an issue if you have automated the process. 3) No, no investor understands tracking error, but they do understand very high levels of documented tax savings or deferral; as for underperformance, tracking error is random, so ½ the time they're outperforming the ETF, and, as noted above, the other half, they're still ahead because of the tax benefits. The wonky direct index details of statistical sampling, tracking error etc can be ignored.}

GMAM’s Response:

The objection that "explaining and processing the portfolio" is more difficult with direct indexing versus ETFs is understandable when discussing traditional direct indexing strategies that may include 200-300 securities. However, each of GMAM’s 6 Compact DI portfolios consists of just 22 or fewer carefully selected stocks, which offers a significant advantage in both portfolio management and client communication.

First, the automation of direct index portfolios remains key—whether you're dealing with 22 stocks or 200. “Processing” the portfolio for rebalancing, tax optimization, or performance reporting is no more complicated than with an ETF, and arguably easier given the much smaller number of positions. Not to mention, the direct index provider will be responsible once engaged for generating and executing all the trades – not the advisor.  

I disagree with Jerry's statement, "Having more securities in an account does slightly increase the frequency of client calls. For large clients this is desirable." Yes, it likely will increase client calls, but I'm not sure that these are the kinds of conversations that necessarily lead to better relationships. This was a factor in our decision to limit our portfolio sizes.  When it comes to explaining the portfolio, a key advantage of our Compact DI approach is that fewer securities mean less complexity. Advisors have fewer line items to discuss with their clients, making the portfolio easier to explain and less overwhelming. For example, reviewing 22 securities is far simpler and more digestible for clients compared to navigating 200+ holdings, some of which the client has never heard of. This simplicity improves the client experience, especially for those who want a clearer understanding of their investments but may feel bogged down by excessive detail in larger portfolios.

Regarding Brents comment of performance “…they're paying more for a direct index SMA and getting hit by underperformance, versus an easy-to-understand ETF."

The Bloomberg Compact Indices which we developed with Bloomberg as the basis for our Compact DI strategies have all historically outperformed their parent indices.  We are the exclusive licensee, feel free to reach out to us for details.

Responding to Brent’s Comment:

1. Tax Return Line Items: While Brent mentions concerns over the large number of line items on a tax return, with GMAM’s 22-stock portfolios, this issue is minimized. Clients aren’t staring at 200+ individual stock holdings. With only 22 or fewer securities, the paperwork is drastically reduced, whether for tax returns, statements, or proxies. In today’s environment of digital tax filing and online statements, the potential complexity associated with direct indexing is further reduced.
2. Transitioning Assets: Transitioning assets in a portfolio of 22 stocks versus 200 is not only simpler but also more cost-effective and less prone to error. Automation ensures seamless transitions, but it’s inherently easier when you’re managing fewer securities. This creates less friction and reduces the potential for client confusion, making the onboarding and portfolio adjustment process far smoother for both the advisor and the client.
3. Tracking Error & Underperformance: Well stated by Brent, and with Compact DI, the simplicity and clarity of fewer holdings allow advisors to focus client conversations on the benefits of the strategy, particularly the tax alpha.