Direct indexing sure looks like the next big thing: Assets in the space totaled $362 billion in 2020, accounting for nearly a fifth of the industry’s total money in retail separate accounts, according to Cerulli Associates. Flows into direct indexing accounts are expected to outpace those into ETFs, mutual funds and conventional separately managed accounts in the next five years, according to the report.
Direct indexing lets investors buy the components of a stock index, and to exclude or include specific tickers as desired. The potential for customization and tax management have made direct indexing a hit. Custom indexer Canvas, in the process of being acquired by Franklin Templeton , announced Nov. 16 that it doubled assets to $2 billion in just nine months this year.
Here’s what advisors need to know about this hot new investing trend:
What it is: Direct indexing is a new wrinkle on customizable separate accounts, which have traditionally only been available to the very wealthy. Made possible by computer algorithms as well as the collapse of trading fees, direct indexing offers exposure to the components of a market index without buying an ETF or mutual fund. Prominent providers in the space include Parametric Portfolio Associates, along with Aperio, Orion, and Envestnet. Advisors generally use direct indexing for clients’ core equity portfolios.
The value prop: Direct indexing can help firms differentiate themselves, particularly for clients who are concerned with tax efficiency. ETFs are more tax efficient than mutual funds, but direct indexing can take tax management to the next level since tax-loss harvesting can be handled on a stock-by-stock basis. It’s believed that direct indexing can boost tax alpha by as much as 1% to 2% in certain cases. Because of how they enable tax-loss harvesting, direct-index solutions are also useful in reducing the risk of too much concentration in just a handful of stocks in portfolios without ringing up a huge tax bill.
Direct indexing also appeals to ESG-minded investors. There are plenty of off-the-shelf ESG funds out there, but pinpoint customization can be a selling point. Manufacturer A and Manufacturer B may both be big polluters, but you might allow Manufacturer B into your portfolio because it has pledged to clean up its act. Direct indexing allows you to thread that needle.
Direct indexing unleashed: Not long ago, high trading fees and other constraints limited the market for separately managed accounts to $1 million or more of assets. The bar has fallen to $150,000 or so, thanks to computer algorithms and brokerage firms’ race to zero in trading fees, which concluded in 2019. That opens up a huge addressable retail market, and explains why in the past couple of years Vanguard bought Just Invest, a newer entry into direct investing; BlackRock bought Aperio; Morgan Stanley nabbed Parametric; Charles Schwab acquired Motif Investing, and Goldman Sachs grabbed Folio Financial. The big players are betting that direct indexing has a bright future.
Some caveats: As anyone familiar with a CRM system can attest, technology doesn’t mean no work is required. Advisors using direct indexing have to do everything from uploading client tax information to making sure clients are in the right models, to confirming that ESG filters are set up properly. Rebalancing can also be challenging in cases where the direct-indexing accounts are traded by a third party. Some firms have created designated positions to deal with such matters.
And direct indexing still isn’t feasible for smaller accounts. The rollout of share fractionalization capabilities by the big custodians would help unlock that market. And it’s noteworthy that Fidelity did begin offering fractionalized share trading to advisors in September. That positions it to theoretically offer direct indexing to advisors.
Finally, some advisors also argue that ETFs’ rock-bottom fees outweigh potential tax savings in direct indexing strategies that can charge 20 or 30 basis points.
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November 17, 2021 at 03:30AM
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Direct Indexing: What Advisors Need to Know - Barron's
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