An interview with Ken Lassner, CFA, direct indexing lead product strategist, Northern Trust Asset Management.

Assets managed using a direct indexing strategy—one based on owning shares directly in companies that constitute a particular stock-market index[1]—are projected to more than double to over $2 trillion by 2028 from the roughly $865 billion managed at the end of 2024. To find out what’s driving this growth and why advisors are increasingly turning to direct indexing as a solution for their more affluent clients, Wealth Management recently sat down with Ken Lassner, direct indexing lead product strategist at Northern Trust Asset Management (NTAM). Highlights of the conversation follow:

Despite the market’s recent record highs, we’ve also seen a lot of volatility and uncertainty. Against this backdrop, what do you see as the key driver or drivers of direct indexing’s increasing popularity?

Two things: First is tax efficiency, because many clients live in high-tax environments, and second is the customization or personalization that direct indexing offers.

For clients and advisors who lean toward having some degree of passive exposure in their investment portfolio, direct indexing can be more advantageous than owning an equity index ETF[2] or an equity index mutual fund.[3] That’s because by directly owning some or all of the stocks that constitute an index rather than a single index fund, investors can take advantage of the market’s natural volatility in which there are always some stocks that go up and some that go down no matter the direction of the market as a whole. When stocks are owned in a separately managed account, or SMA, which is the vehicle most often used for direct indexing, you can sell the stocks that went down and create a tax credit. And that credit can be used to offset capital gains from other investments, which means that more of your capital is working for you over time. Also, an SMA allows the investor and the advisor to customize an index by underweighting, overweighting or eliminating certain companies to suit unique circumstances or preferences.

Customization, of course, implies that the SMA portfolio doesn’t precisely track its index. Is that a problem?

It’s actually an opportunity. At Northern Trust, our tracking error tends to be between 50 to 75 basis points, compared to something like 2 basis points for an ETF. The difference arises because when we track the S&P 500,[4] for instance, we hold only about 300 to 350 stocks, not all 500. But the 150 or 200 stocks we don’t hold create a replacement universe, so that if Coca-Cola goes down, for example, we can replace it with PepsiCo. Tracking an index with greater leeway enables us to do tax-loss harvesting, which generates 100 to 200 basis points of excess return after taxes versus an ETF with a very similar exposure. For investors, tax-loss harvesting is a much more consistent generator of alpha than stock picking, because it takes advantage of the natural volatility that happens no matter what the market is doing, and from which you can’t benefit if you own an ETF. What’s more, customization allows an investor to modify a portfolio based on unique concentration or investment philosophy considerations.

How involved are advisors in making these customization decisions when they use NTAM?

We have a very consultative approach, so an advisor can be as involved as they want to be. Some like to do the customization themselves, but very frequently advisors ask us to help them figure out the best way to diversify a concentrated position over time in a way that is tax efficient without taking on too much risk. Since we’ve had experience managing institutional direct indexing portfolios for more than 35 years and are now the third largest direct-indexing manager, we’ve addressed pretty much every challenge an advisor might face.

What new trends or shifts in the direct indexing market have you seen recently?

With this year’s greater volatility, it’s very important for an advisor who manages a direct indexing portfolio to monitor accounts daily and possibly rebalance them more frequently. To do that, technology can be very helpful, so we introduced desktop tools recently that give advisors greater control and visibility into their direct indexing portfolios. At NTAM, we monitor accounts every day and typically rebalance them about once a month. But during periods of significant volatility, we rebalance more frequently. This year, through March, when the S&P 500 was down 5%, our loss-harvesting volume was double the average of the previous 24 months.

Do this year’s IPOs change anything vis-à-vis direct indexing?

Not per se. When an initial public offering (IPO) makes its way into an index, we include it. But because of the tax impact, how much of an IPO we put in individual positions will vary. Still, the float that’s being generated by IPOs is relatively small, and indexes have different rules about inclusion. Take SpaceX as an example. FTSE Russell[5] and MSCI[6] will be a little quicker with inclusion than S&P, which says it won’t put the stock in its S&P 500 Index for 12 months.

Research seems to suggest that advisors using direct indexing are likely to see stronger retention and wallet share. Has the strategy’s success made using it table stakes or is it still a differentiator?

When I started in direct indexing over 20 years ago, there were very few advisors who had even heard of it, and minimums were $5 million. Today, most minimums are $250,000 and some are as low as $100,000. Investor demand and technology have made the strategy available to a much wider audience, and advisors are finding that direct indexing leads to much more meaningful conversations about investing, as well as about taxes, charitable giving and estate planning. Among more affluent investors, those issues are very important.

Are tax-managed long/short strategies complementary to direct indexing or a potential alternative?

I view them as complementary. Long/short strategies can make sense in some cases, such as when a client sells a business and needs help offsetting as much of the gain as possible, or when someone receives a significant amount of stock and wants to diversify quickly because they’re worried about concentration risk. But there are many issues to consider. IRS rules regarding long/short sales are complex, and the agency looks at transactions very carefully. Also, cost of carrying and unwinding short positions can add up. In the vast majority of cases, I think clients can find direct indexing to be a more effective solution.

Can retirees benefit from direct indexing?

It’s funny, one of the criticisms of direct indexing is that as the portfolio ages, it “ossifies,” meaning that there aren’t as many losses to take as there were in its early days. But the irony is that during the time an investor uses tax savings to offset capital gains, their capital stays invested and continues to grow. Essentially, the tax savings are compounding, and the longer the deferral and compounding go on, the better off you are from a wealth perspective after taxes. If you never sell the direct indexing portfolio, it goes to your beneficiaries and gets a step-up in basis. For children or grandchildren, that can be a wonderful inheritance.

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[1] A statistical tool typically created and managed by an asset management firm or financial information company that is used to measure and track the performance of the entire stock market, a segment of the market or a particular group of companies.

[2] An equity index exchange-traded fund (ETF) is a closed-end investment company whose fixed number of shares trade on an exchange. Its portfolio consists of shares in companies that are components of a specific stock-market index, and it is designed to track, or mirror, the performance of that index.

[3] An equity index mutual fund is an open-end investment company, which issues and redeems shares based on buyer and seller interest. Like an equity index ETF, its portfolio consists of shares in companies that are components of a specific stock-market index, and it is designed to track, or mirror, the performance of that index.

[4] The S&P 500 (officially, the Standard & Poor’s 500 Composite Stock Price Index) tracks the stock performance of 500 leading U.S. companies, accounting for about 80% of the total market capitalization of U.S. public companies.

[5] The FTSE Russell Group is a provider of global financial indexes, data, and analytics.

[6] MSCI is a financial research firm that builds and manages benchmark stock indexes. It was formerly known as Morgan Stanley Capital International.