Direct Indexing to Grow Faster Than ETFs, Mutual Funds: Cerulli

Cerulli Associates projects that direct indexing assets, which currently total over $300 billion in separately managed accounts, will grow at a 12.4% annualized rate over the next five years, topping even the growth rate for ETFs, projected at 11.3%.

Initially the growth will come from “high-end advisors” serving wealthy clients but inevitably growth will move downmarket as a result of “new market entrants,” technology and low-cost trading, according to Cerulli, which just published a white paper on the topic.

The paper was sponsored by Parametric, a major provider of direct index SMAs owned by Morgan Stanley. Parametric accounts for about one-third of the $362 billion direct indexing assets, followed by Aperio, owned by BlackRock ($45 billion) and Fidelity Investments ($24 billion).

The white paper notes that a low-end direct indexing solution can act as a differentiator for advisors to attract new clients including those who are not wealthy now but will potentially inherit their family’s wealth.

As it stands now, the heaviest users of direct indexing are advisors focused on its tax benefit capabilities. Direct indexing allows advisor clients to directly own all or a customized assortment of individual securities in an index without purchasing a mutual fund or ETF.

“The tax savings generated by direct indexing are a way for these advisors to generate quantifiable value for their clients,” according to the Cerulli white paper.

But direct indexing through SMAs provides several other key benefits for advisor clients:

• the ability to match investments to personal values, including a preference for securities that score high on environmental, social and/or governance factors or excluding those that don’t
• the ability to diversify away from a concentrated stock position when an investor is compensated with company stock or away from an industry in which an investor works
• the ability to donate specific securities to charities and receive a tax deduction

“The applications are wide-ranging, but direct indexing is not a fit for every client or situation,” according to Cerulli. Advisors who are dedicated to active management and are not comfortable with passive investing, for example, are likely not a good fit for direct indexing despite its benefits. The same can be said for advisor clients who have most of their assets tied up in retirement accounts, which wouldn’t receive any tax benefits from direct investing.

Direct indexing is used primarily for stock portfolios, but it is increasingly being used for fixed income portfolios, according to Cerulli. “Investors can directly own a customized assortment of individual bonds that can replicate the risk/return characteristics of a corporate bonds index,” according to Cerulli.

It notes that a number of asset managers including Parametric, BlackRock and Nuveen are offering customized laddered fixed income SMAs. Such an approach can be especially beneficial for a bond ladder of municipal bonds, which are usually held because of their tax benefits.