Forget robo advisors, financial planning software or risk-assessment tools. One of the hottest wealthtech acquisitions right now are the companies helping advisors offer a previously inaccessible investing strategy called direct indexing.
This week, Vanguard became the latest financial institution to buy its way into direct indexing when it
Vanguard’s championing of low-cost exchange-traded funds that track benchmarks like the S&P 500 have helped it grow into one of the world’s largest asset managers, with $7.9 trillion globally. But the idea of direct indexing is to replicate the performance of an index fund by purchasing the underlying securities instead of a product that wraps them together.
“If I were in Vanguard’s shoes, what direct indexing does is it kind of threatens the value proposition of the ETF and the index mutual fund,” says Tom O’Shea, a research director at Cerulli Associates.
While ETFs won’t be replaced anytime soon, if ever, O’Shea says direct indexing has certain advantages — primarily around tax-loss harvesting and ESG investing — that are increasingly attractive to financial advisors. Over time, this could direct flows away from some products, especially ESG ETFs.
“It gives advisors a way to add value to people who are looking for more than just beta exposure,” he says.
Direct Indexing has been around for decades but was traditionally only available to ultra-wealthy clients. In 2017,
Now, the company is singing a different tune. Vanguard has been testing a direct indexing service for a year and a half and plans to use Just Invest to give bank, broker-dealer and RIA clients of its $3 trillion intermediary business “the ability to personalize investment portfolios to reflect investors’ values, financial objectives, and tax-loss-harvesting needs,” according to a statement.
“Technology-driven solutions such as direct indexing continue to reshape our industry, driving better investment outcomes and lowering costs for clients,” said Vanguard CEO Tim Buckley in the statement.
What changed? A number of industry trends have combined to make direct indexing more accessible to a greater number of financial advisors and clients. For example, technology first introduced by the robo advisors has automated what was traditionally a labor-intensive portfolio construction and rebalancing process, O’Shea says.
Meanwhile, the rise of fractional share investing and zero-commission trading are making the strategy accessible to more than just ultra-wealthy investors, says Awaad Aamir, a securities and investments analyst at research firm Celent.
“It’s part of this trend around democratizing services that were exclusively only available to high net worth individuals who used to forge their own ETFs and index mutual funds for tax purposes,” Aamir says in an email. “Mass-affluent clients present a significant opportunity for online brokerages, and direct indexing is one way to appeal to them since they have a greater interest in personalized portfolios and taking advantage of tax-loss harvesting than mass market [consumers].”
Vanguard is far from the only firm now interested in direct indexing. In October, Morgan Stanley
Charles Schwab is expected to launch a direct indexing service that combines
“A lot of [direct indexing fintechs] have already been Hoovered up,” O’Shea says.
The trend goes well beyond any worry about direct indexing disrupting the ETF market, O’Shea says. Two-thirds of asset management firms identified managing taxes and ESG investing as significant opportunities for direct indexing, according to
Nearly half (47%) of managed accounts don’t receive any tax treatment, according to the Cerulli report. However, a separate report from Celent found that the ability to harvest losses with direct indexing can generate an average of 1% to 2% annually in tax alpha compared to ETFs or mutual funds.
All of the consolidation proves the immense demand for direct indexing from financial advisors, says Doug Scott, CEO of Ethic, another asset management platform using technology to provide direct indexing strategies to independent advisors.
“Personalization means creating something that you can connect with,” Scott says. “If you unbundle the term 'ESG' and think about what it means, it’s issues that are important to you. It’s adding another dimension to advisor-client engagement.”
Another benefit of direct indexing could be that it creates stickier clients, and not just because they enjoy the personalization or tax benefits, says David Goldstone, manager of research and analytics for Backend Benchmarking. It’s just simply more difficult for a client to change firms when they own fractional shares of 200 different equities instead of just 10 ETFs.
“It makes the product more sticky and increases the cost of moving to a new manager,” Goldstone says.
Firms are looking to roll out direct indexing for different reasons, but it’s clear that direct indexing is at the forefront of the latest wealthtech arms race. The flurry of acquisitions — especially from companies who traditionally build technology in-house — shows that firms are looking to get these products to market as quickly as possible, O’Shea says.
“There’s a sense of urgency on the part of the large firms to make sure they get into this space,” he says. “If they aren’t moving quickly, they are going to be left behind.”
