"Direct indexing makes tax return prep harder"

This appears to be an imaginary problem. But that's not the point.

⚾ Quick note: No mid-week email this week. I’ll be in Phoenix for spring training with my family.

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"Direct indexing makes tax return prep harder"

Ask a room full of financial planners, advisers, and wealth managers about direct indexing, and it will split into camps.

One camp thinks the direct indexing “juice isn’t worth the squeeze.”

The opposite camp thinks anyone disregarding direct indexing violates their fiduciary duty.

A third camp believes direct indexing is a gimmick.

I captured these camps in a graphic a while ago, summarizing what advisers had told me over the previous few months.

My pal Jerry Michael at Smartleaf wrote a thoughtful response cum rebuttal saying Direct Indexes Make Sense for Investors Worth Less Than $1mm and Over $5m.

But since I regularly hear complaints about how “inconvenient” direct indexing is, I recently polled my audience about whether direct indexing is annoying around tax time.

92% of respondents (68/74) said computers, not humans, solve the problem, which suggests it is likely imaginary (at least to my tech- and tax-savvy audience).

Maybe I was asking about the wrong inconvenience?

Jerry responded that advisers sometimes argue that “[direct indexing is] harder to explain” or that they don’t like “long statements,” which squared with what I've heard.

There are two things at play here:

1. Some technology is direct indexing “lite,” meaning it’ll check the direct indexing box but is a pain to use.

2. There are holdouts who think the juice isn’t worth the squeeze.

The technology adoption curve

Geoffrey Moore’s technology adoption curve from his excellent Crossing the Chasm comes to mind when I think of direct indexing adoption.

It says, more or less, that new technology adoption moves from a few innovators to the mainstream once it crosses the viability chasm and eventually to skeptics/laggards who give in due to social or competitive pressure.

The driving force behind this progression is word of mouth. Unsurprisingly, we trust our leaders and friends more than sales and marketing.

So, when someone dismisses direct indexing as “inconvenient,” I see two possible outcomes:

1. Eventually, they’ll come around because the marketplace forces it.

2. They will never come around because they have explainable alternatives.

Here’s an example: Christopher Walken has never owned a cell phone. He’s a consumer celebrity, which implies little social and no competitive pressure.

He’s allowed to opt-out.

Here’s another example: An adviser uses exclusively sector ETFs for their clients. They have competitive pressure, but since direct indexing is hard to explain and ETFs are low-cost and tax-efficient, this solution is better than “good enough” it is “explainably good.”

The adviser is allowed to opt-out.

For example, the folks at Elm Wealth have argued for a portfolio of sector ETFs over direct indexing.

And while direct indexing is growing, its very-plausible alternative, ETFs, are growing too.

How is that possible if direct indexing is such a slam dunk and an order of magnitude smaller? It should grow much faster (as tax-aware long/short strategies are…).

One reason is that it’s more complex, and it’ll take time for the message to permeate the market.

In Thiel’s Zero to One, he says a competitive product needs to be 10x better than the incumbent to win business. Direct indexing seems to be landing short of that benchmark.

In other words, the marketplace is screaming, “The juice isn't worth the squeeze.”

Don’t waste time on holdouts

Many people want to add extra alpha using direct indexing or hedge idiosyncratic risk or express a value preference.

So, with scarce resources, why not just focus on them?

Practically speaking, that means at least two things:

1. Having a really crisp idea of the customer and the specific problem they’re solving.

2. Using sharper opinions in marketing.

“Wealth managers” is not a crisp customer definition.

“My competitors’ clients who feel dissatisfied with their current direct indexing solution” is much better because there's no need to fight about whether the juice is worth the squeeze. Everyone agrees it is.

Nagging advisers with lines like: “evaluating direct indexing is part of your fiduciary duty,” won’t work. Advisers, business owners, CIOs, consumers, etc., have limited time and energy, and guilting them is highly ignorable.

Instead, tickle their preferences.

Create a cult around whatever you’re best at. “We do X better than anyone, and here’s the proof” (preferably shown rather than told).

This will attract people excited about X. Those are the right people.

If you’re now thinking, “Well, nobody is really listening to me, or I can’t find these people easily, so this crisp customer definition and clear marketing you’re suggesting is bullshit.”

I hear that, and if no one is listening to you, then you have a more fundamental branding problem.

Poor (or no) branding means you’re not getting shortlisted. You’re getting eliminated before the first sales call.

So, let me back up and point out that a crisp customer definition, and clear, opinionated marketing, is table stakes.

To win attention, to build a brand, your content needs to be industry-leading.

Sounds crazy, right?

But, how often do you think: “Well, this is a mediocre blog post, but I’ll read it anyway.”

Never.

There’s one workaround that’s worked forever: Showing up in person.

That’s why many large, established wealth and asset management practices have such shit marketing (or no marketing at all). Because their sales engine is dialed in (or their product is so stellar, Renaissance’s Medallion fund comes to mind that the product itself is marketing, but this is rare).

The point is to focus on finding the right customers and on delivering clear, industry-leading content that speaks directly to them.

Easier said than done, but is a better use of resources than trying to convert holdouts who have an explainable alternative and may never adopt.

Thanks for reading.