Wealth managers can get the sort of investment performance from a benchmark such as the S&P 500 without having to hold a mutual fund or ETF. This is known as direct indexing. What are its advantages and why are people getting into this area?

Direct indexing may be approaching an inflection point.

“It’s the next evolution [in investing] and it’s not likely things will be the same ever again…this is unequivocally where the puck is going,” Josh Brown, the CEO of Ritholtz Wealth Management and well-known industry commentator, wrote in his Reformed Broker blog.

Direct indexing’s potential for mass customization is the “Holy Grail” for asset managers, according to a senior industry executive interviewed by Cerulli Associates, a financial services research firm.

Since the end of 2017, retail assets for Parametric Portfolio Associates, the largest provider of direct indexing, has risen by nearly 300 per cent to more than $150 billion.

Direct indexing enables industry practitioners to replicate performance of an index by directly owning the underlying securities rather than doing so through a mutual fund, for example. Hence the term “direct investing."

New assets will continue to flow steadily into direct indexing, according to Scott Smith, director of advice relationships for Cerulli.

“The growth of direct indexing will be incremental,” Smith said. “The money won’t come from existing accounts but we’re expecting to see new money flow into direct indexing.”

Wealth managers also anticipate increased interest in the investment product.

“We’re using direct indexing and our advisors and clients are still getting comfortable with it,” said Brian Katz, chief investment officer for The Colony Group in Boston. “It’s not a material percentage of our business yet but is a growing component of our investment offering.”

“Indexing is a big part of our investment philosophy and direct indexing is like traditional indexes and ETFs on steroids,” said Jonathan Straub, principal at Los Angeles-based RIA AdvicePeriod. “I’m surprised more people aren’t using direct indexing yet but I expect that’s going to change.”

Wall Street on board
Certainly one of the factors driving that change are the large bets Wall Street powerhouses are placing on direct indexing.

In the last six months alone Parametric was acquired by Morgan Stanley as part of its Eaton Vance deal. BlackRock, the world’s largest asset manager, bought Aperio Group, the second largest provider with over $35 billion in retail assets for $1 billion in cash, and Goldman Sachs purchased Folio to add to its growing stable of investment offerings for retail clients.

Ironically, “direct indexing” may be a misnomer, reminding some of the old history joke about the Holy Roman Empire, which, wags pointed out, was neither holy, nor Roman, nor an empire.

“I don’t think ‘direct indexing’ is the right term,” Smith said. “‘Customized separately managed account’ would be more accurate.”

Direct indexing is really “software-facilitated mass customization for the masses,” Morningstar analyst Ben Johnson told Wealth Management. Indeed, O’Shaughnessy Asset Management calls Canvas, its direct indexing product, “custom indexing.”
 

So what exactly is direct indexing?
Fintech giant Black Diamond describes it as “the ability to replicate an index by directly owning the underlying securities instead of an ETF or mutual fund.”

Thanks to no-cost trading and the ability to buy fractional shares easily, advisors can now create a personalized basket of stocks for clients that account for tax-loss harvesting ESG requirements and concentrated positions.

Direct indexing is widely viewed as the latest investment evolution following in the footsteps of mutual funds and exchange traded funds. Moreover, it represents a new, more flexible approach to a separate account structure without the high costs and complexities which heretofore have limited SMA use to high and ultra-high net worth clients.

Generating tax alpha and building selectively around concentrated stock positions are direct indexing’s primary benefits, according to Katz. “It’s a really good tool for mitigating taxes from an inherited portfolio of low-basis stocks,” he said.

What’s more, direct indexing can also be a significant “point of differentiation” for advisors, according to Cerulli’s Smith.

“People want personalization,” Smith said. “Direct indexing allows advisors to offer customization, and that’s what clients really want - to have someone hear their story.”

What about the risks associated with direct indexing?

The biggest red flag, according to advisors, is the possibility of tracking error, or the deviation of the product’s performance from a traditional index, such as one modeled on the S&P 500.

“We’ve been using Parametric for years and they’ve done a great job of replicating benchmarks,” said AdvicePeriod’s Straub. “But clients have to be comfortable with tracking error. And even if they have to give up a percentage of total performance, they can usually see tremendous tax benefits.”

Implementation of direct indexing can also be “troublesome,” Smith warned.

“Excessive customization can lead to complications that can be overwhelming,” Smith explained. “The biggest challenge facing advisors using direct indexing is the intricate nature of the accounts.”

Direct indexing can also border on active investing.

“The line blurs a little” when direct indexing takes into account a factor tilt or ESG stocks, Katz said. And while AdvicePeriod uses direct indexing to be “active in investing,” Straub says that’s different from actively “trying to beat the market.” 

Will ETFs suffer?
Looking ahead, ETFs are expected to bear the biggest brunt of direct indexing’s expected growing popularity.

Cerulli believes that mutual funds will continue to lose market share, but instead of ETFs gaining around 80 per cent of new flows, the rise of direct indexing will reduce that growth to approximately 60 per cent.

As for how big the coming direct indexing wave will be, look no further than Wall Street’s marketing machine.

“I’m wondering how much BlackRock is going to drive direct indexing,” Straub said. “I think that will have a big impact.”