In 1992, a large family office approached a boutique asset manager based in Seattle for help with an investing challenge. The client was tired of the vagaries of asset management and wanted a portfolio that behaved like an index but with more after-tax considerations than traditional passive strategies allow for.
The answer was a custom-built portfolio that, instead of consisting of ETFs or mutual funds, directly purchased the hundreds of securities those funds contain. This allowed the portfolio to passively track a benchmark specified by the client, but also let the portfolio managers sell individual stocks at a loss to offset capital gains taxes.
That portfolio was one of the inspirations for direct indexing, a strategy that has powered Parametric — that Seattle-based boutique — to $428 billion in assets under management over 30 years. Eaton Vance acquired Parametric in 2003, and in November 2020,
“It took a long time for the idea that you should be cognizant of, and managing for, after-tax portfolio performance to take root beyond just the most cutting-edge, UHNW advisory community,” said Brian Langstraat, who began at Parametric in 1990 as a portfolio manager before taking over as CEO in 2001. “More interest in this space is good for the investors and good for Parametric. We’ll do less evangelizing and less missionary work, and more investing and creating portfolios for advisors and clients.”
The Morgan Stanley deal was just one of a dozen recent examples of financial institutions buying into direct indexing, which has
Charles Schwab, Goldman Sachs, CI Financial, J.P. Morgan, Franklin Templeton, Prudential Global Investment Management, Pershing and UBS have all bought in. Meanwhile, Fidelity Investments is
After operating in relative obscurity for 30 years, direct indexing suddenly became table stakes for financial institutions, which expect product customization to power the next generation of growth. Even if built automatically, direct indexing technology gives firms the ability to say they can give every customer, regardless of asset size, a custom portfolio tailored to their exact specifications.
The assets are following. Direct indexing claimed $362 billion in 2020, nearly one-fifth of the total retail separate account assets, according to a report by Cerulli and Parametric. Assets in direct indexing are expected to grow at an annualized rate of more than 12% over the next five years, outpacing traditional products like ETFs and mutual funds. They should cross the $1 trillion threshold by 2025, according to the report.
“That blew my socks off,” said Tom O’Shea, research director for managed accounts at Cerulli Associates. “It’s been a millionaire’s product from the very beginning … now it’s in the hands of the mass investor.”
High costs meant high minimums
To understand direct indexing’s sudden explosion into the mainstream, it’s worth looking at why it remained on the margins of wealth management for so long.
To start, there were no tools to manage the tradeoffs between passive portfolios, tracking error (the divergence between the portfolio’s behavior and the benchmark) and taxes. Managing hundreds of equities in a single portfolio required a lot of work.
“A lot of it was done in spreadsheets. There weren’t a lot of accounting systems that would successfully track tax losses,” Langstraat said. “There was a time when I would go make the client pitch, I would facilitate the signing of the contract, open the account at the custodian and build the portfolio, build the reports and deliver the client meeting.”
With few people even talking about direct indexing in the 1990s, firms like Parametric and Aperio had to conduct and publish their own research while also developing risk models and early versions of technology. There was a lot of networking to figure out which tools could be adapted and which had to be built from scratch.
“Six years ago, a lot of advisors weren’t necessarily aware of this and didn’t always have access to it or an understanding of all the benefits,” said Monali Vora, head of direct indexing and custom equity at Goldman Sachs Asset Management.
It was also expensive — very expensive. Mimicking an index requires holding at least 250 securities, which requires a sizable minimum investment.
“In order to get an S&P 500 index that allowed for tax management, you had to have at least $250,000 to $500,000, and that’s just your core exposure,” said O’Shea. “For your whole portfolio, you would need to have about $2 million, at least.”
The high minimums and heavy workload meant the strategy really only made sense for the wealthiest of clients — usually those with $10 million or more to invest — and the small number of advisors who served them.
Industry trends knocking down barriers
Several industry trends over the last decade have knocked down those barriers to entry.
Digital innovation is arguably the biggest factor. New trading engines make it much easier to quickly buy hundreds of shares and automate tasks like rebalancing and tax-loss harvesting.
There’s also what Dennis Gallant, a strategic advisor for Aite-Novarica’s wealth management practice, called “the Robinhood effect.” The trading app popularized fractional-share trading, which allows investors to buy pieces of expensive stocks such as Apple and Amazon. Robinhood also featured zero-commission trading, which quickly put pressure on other online brokerages to follow suit. In 2019, nearly every online brokerage had dropped commissions from self-directed trading.
Both innovations helped to reduce investment minimums. Without needing to pay full price for exposure to blue-chip equities, investors could directly own most or all of the underlying shares in the S&P 500 with a much smaller investment. And without having to pay commissions for every trade, an automated system could constantly search for tax-loss harvesting opportunities without worrying about cost offsetting the tax alpha.
Goldman, for example, has been able to reduce the minimum on its direct indexing service from $10 million to $250,000, said Vora.
“That’s something that I personally spent a lot of time on,” she said. “Taking that UHNW solution and democratizing it.”
Changing attitudes about passive investing and an embrace of the algorithmically created portfolios popularized by robo advisors have fostered an environment where direct indexing makes sense for more advisors.
“There’s a changing perception of what investing for private wealth should be and how advisors focused on private wealth should act,” said Langstraat. “Advisors are moving away from stock selection to [concentrate on] asset allocation and financial planning.”
Limitations
There are some who remain skeptical about just how far down market direct indexing can come.
Offering the strategy at scale still entails a great deal of complexity. Owning several hundred stocks raises questions about proxy voting and quarterly reports the size of Russian novels. The benefits of direct indexing — customization and tax-loss harvesting — require sacrificing the simplicity of buying a single, low-cost ETF. That’s an easy trade-off for HNW clients, but the benefit might not justify higher premiums for smaller investors.
“They go from getting a six-page statement to a 100-page statement and endless 1099s at the end of the year — maybe not in line with what the client is expecting. Is it worth all of that additional complexity?” said Derek Hernquist, head of advisor experience at Aptus Capital Advisors, a $3 billion asset manager.
Hernquist also wonders if thematic investing built with direct indexing could end up limiting portfolio diversification for retail investors.
“When you get to the direct-to-consumer market, the concern is you end up with some clients who jump on certain themes and misread owning a bunch of names as having diversification when they don’t,” Hernquist said. “[Direct indexing] loses all benefits if it becomes concentrated in a specific center. You might as well just own an ETF.”
There could also be complications with onboarding clients and helping them understand how the solution differentiates from other products, such as a lower-cost robo advisor. Advisors will also need to be trained on the benefits of direct indexing and why it’s worth adopting a new system.
“It’s asking advisors and investors to think about their equity investments in a different way,” said Vora.
On the technology front, firms must ensure that trading systems are efficient and effective so direct indexing doesn’t end up costing more than anticipated, Gallant said.
“You’re taking a product that has been very much built for the smaller, HNW market,” Gallant said. “If you open it up to a broader audience, the volume of customization can be astounding.”
Producing quantitative data on ESG impact and tax optimization can be easier said than done, said Michael Daly, a senior consultant with Capco, a business and technology management consultancy firm with a focus on financial services. So is building it into a user-friendly application that supports client and advisor interactions.
The winners in the space are going to be companies who successfully use direct indexing to align a portfolio with investors’ values and preferences, successfully communicate the tax alpha added and avoid an overly complicated digital user experience, said Robert Norris, a managing partner at Capco.
Why companies are buying in
The key driver behind the sudden interest in direct indexing is a widespread belief that customization will be a key driver across wealth and asset management over the next decade, even more so than
The rising popularity of ESG investing over the previous decade also created demand for more customization in passive strategies than can be offered in classic ETF portfolios. Rather than build a portfolio of ESG-specific funds, an advisor can use direct indexing to remove companies a client objects to from an index (and even replace it with something else to reduce tracking error). Or, advisors can customize portfolios for clients overweighted in certain positions from a self-directed brokerage account or their employer’s stock.
“[Clients] want much more tailored and specific investing,” said Scott Reddel, who leads Accenture’s wealth management practice in North America. “I’ve heard wealth management firms talk about ... the degree we can tailor investments to match your financial plan at the atomic security level.”
Norris added: “Advisory firms are looking [at direct indexing] and saying, ‘I can be even more customized, more personalized, but for the same level of cost and effort,” Norris added.
While direct indexing may be a difficult concept to explain, advisors could find that telling clients which specific companies they are invested in may be more engaging than just giving them a list of ETF tickers — especially for those who began investing on self-directed apps.
“You not only have control of your money, you know how money is being invested,” said Norris. “It’s not just in some black box, S&P 500 fund.”
Where is this going?
While nearly all direct indexing AUM has been with boutique asset management like Parametric and Aperio, new products for advisors and retail consumers could start a shift.
“I’ve heard three years; I’ve heard five years; I’ve heard 10 years for direct indexing to really establish itself in the market,” said Gallant. “The next generation of the direct indexing world really starts later this year.”
However, Fidelity’s launch of Managed FidFolios could significantly crunch the timeline. Though no one expects direct indexing to create substantial outflows from ETFs anytime soon — direct indexing isn’t very useful for tax-advantaged retirement accounts — all eyes are on how the brokerage’s direct-to-consumer product resonates with the retail market.
While not everyone is certain it will resonate among mass market investors, few doubt the opportunity to continue expanding direct indexing to more investors.
“This is the year we’re going to start seeing the products roll out,” said Gallant. “This is just the start of the wave — just the foundation. If consumers really eat this up and start to go in, who knows where it will go?”
