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Trendspotter: Direct Indexing Poised to Hit the Mainstream

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What You Need to Know

  • Investor demand for customization and tax loss harvesting are key drivers for the growth.
  • Vanguard's first acquisition is Just Invest, a direct indexing upstart; BlackRock has also made acquisitions in the space.
  • Technological advances and commission-free trading make it possible to offer direct indexing more widely.

The Trend

Direct indexing, which replicates an index of securities by purchasing the underlying equities instead of an ETF or mutual fund, could be on the cusp of explosive growth.

The strategy, which allows for more customized portfolios than can be found in index ETFs or mutual funds, fits well with investors’ desires for investments to reflect their values while also helping to minimize their taxes. (Direct indexing is most relevant for taxable accounts.)

It has historically been available to ultra-high-net worth investors through separately managed accounts (SMAs) but appears poised to expand its reach to far more clients, including those with fewer assets. Why else would Vanguard decide to make its first-ever acquisition, agreeing to buy Just Invest, a direct indexing upstart with $1 billion in assets, in a deal announced last week?

“The significance of that was really big,” says Ben Johnson, director of global exchange-traded fund research for Morningstar. “It points to this capability … being made more widely available to a bigger number of investors.”

That same week BlackRock, which earlier this year acquired Aperio, a provider of customized, tax-optimized index equity SMAs, bought a minority stake in SpiderRock Advisors, a $2.5 billion Chicago-based provider of customized options strategies for U.S. wealth managers, to expand its SMA capabilities.

Earlier this year Morgan Stanley acquired Parametric, the biggest custom indexing acquirer, when it closed on its acquisition of its parent company, Eaton Vance.

The Drivers

  • Investor demand for more customization, including investments that focus on environmental, social and governance factors and low-volatility strategies
  • The growing availability of fractional share trading, which allows small amounts of money to be invested in every position of a broad index, providing access to even small investors
  • The increased ability for tax-loss harvesting compared to index ETFs. With direct indexing, investors can harvest losses on individual shares, something they cannot do with an index ETF.
  • Technological advances allowing for algorithmic portfolio construction
  • Commission-free trading, which eliminates high costs for these portfolios
  • More direct indexing offerings from asset managers via SMAs and from at least one robo-advisory platform — Wealthfront — which is driving others to develop their own products.

The Buzz

Cerulli Associates, The Cerulli Edge — U.S. Monthly Product Trends, March 30, 2021

“The growing adoption of fractional share trading, the elimination of commissions, the greater acceptance of algorithmic portfolio construction, and the widespread investor demand for beta exposure have combined to make it possible for these products to move downmarket, into the  affluent and mass-affluent investor tiers.”

Ben Johnson, director of global exchange-traded fund research for Morningstar

“A lot just has to do with choice, which ties back to a trend that we see everywhere. At a Starbucks counter no two drink orders are alike … Eventually this will be a product for the masses … Vanguard, with a lot of the firm’s growth at the margin in the intermediary space over the past 10 years catering toward advisor clients, almost had to do it [acquire a direct indexing firm]. It’s table stakes if you’re going to remain useful to advisor clients …

“As it stands today this is going to be incrementally more expensive than a diversified portfolio of ETFs. How much more expensive is difficult to say. Each portfolio will be different. Will be on an investor-by investor basis.”

Dennis Gallant, senior analyst for Aite Group’s wealth management practice

“These are early days. Firms are showing higher interest … [Direct indexing] has the potential to play a bigger role in investment management. … It opens a whole cadre of solutions that allow active managers or advisors to overlay certain elements to tweak a portfolio … [but] It will be 18 to 24 months before anyone has a better sense of where the market is going …

These solutions will be part of investment product offerings in the future. There is no doubt about that. … This is a way to demonstrate more value, more alpha out of portfolios by tweaking it. … Everyone is clamoring for something to differentiate themselves. Advisors are intrigued. … This will erode some of the [mutual fund and ETF] marketplace.

Bryce Skaff, co-head of Global Client Group, Dimensional Fund Advisors

[DFA has a pilot program of SMAs using four equity strategies with much lower asset minimums  — about $500,000, versus several million dollars or more for many SMAs elsewhere.]

“I know there have been a lot of acquisitions happening in this space. We could have done that, but we wanted to build something internally that was specifically targeted for our community of advisors… What we will be coming out with will not by accident be incredibly competitive … Technology has created opportunities to lower the barriers of entry. We want [an offering] that is systematic, efficient, scalable and low cost to clients. … ESG is a material element here.”

Anton Honikman, CEO of MyVest, a subsidiary of TIAA

“Direct indexing offers a “very important role for advisors…not in the purchase of a product but in the consultative iterative process that reflects the circumstances, preferences and values of investors in a custom solution… It is customer-centric…

“Direct indexing today is typically provided through third-party managers who partner with advisors to build SMAs with them. SMAs are getting the bulk of the money. Where it’s headed [is] advisors asking ‘How can I dis-intermediate the manufacturer by doing it ourselves?’’ [providing] a role for advisory enterprises and large wealth management organizations to build the technological capability to build it themselves. They can keep it in-house and use in-house portfolio management capabilities and figure out how to scale that so the advisor is much more in a relationship management role.”


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