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 …
